Unshell directive – the future started yesterday. What can be done today?
The European Commission (EC) has initiated the so-called “Unshell” directive (also known as ATAD 3), which is designed to prevent the misuse of “shell” companies and to fight tax evasion and avoidance across the EU.
The EC proposed the new regulation in December 2021, after the International Consortium of Investigative Journalists and one hundred and fifty media partners published the Pandora Papers, an investigation based on a leak of 11.9 million files from fourteen offshore service providers.
Although there is still no final consensus on the proposed text of the Directive in the EU Council, the proposal currently raises more questions than it provides answers. Who are these “shell” companies, and why is identifying them so important? What are the main provisions of the proposed Directive and the possible consequences for the taxpayers?
What are the goals of the initiative?
The EC seeks to ensure that EU business structures — which include companies that lack economic substance and are used for aggressive tax planning or avoidance purposes would be identified, registered, and face tax consequences (see figure below).
The EC’s proposal aims to establish new minimum standards of economic activity and set up substance in all the EU member states, so the possibilities of tax planning via purely formal arrangements would remain as little as possible.
To whom would the provisions of the Directive apply?
To a certain extent, the proposed Directive is relevant for all companies operating in the EU and even for their shareholders (individuals). The Directive proposes a multi-level filtering mechanism whereby only companies that lack economic substance and pose the highest tax risk would be selected from all companies established in the EU to face tax consequences.
The Directive will not apply to certain companies due to the significantly lower-risk profile, for example, listed companies, certain regulated financial undertakings, and companies with at least five full-time employees exclusively carrying out the activities generating passive income.
In the first stage, companies should perform a self-assessment test demonstrating whether the company is considered risky. The draft Directive presents three “gateway” criteria:
- Passive Activity Criterion. This first criterion is met if more than 75% (further proposals tend to lower the threshold to 65%) of the company’s total income during the preceding two tax years was received from passive activities. Such income includes interest, royalties, dividends, and income from the disposal of shares, income from financial leasing, income from immovable property, income from movable property (except cash, shares, or securities held for private purposes) with a book value above one million euros, income from insurance, banking, income from services which the company has outsourced to other associated companies, and other financial activities) or if the book value of a company’s immovable or movable property of high value (held for private purposes) is more than 75% (65%) of the total book value of the company’s assets.
- Cross-Border Activity Criterion. This second criterion is met if the majority (more than 60% — further proposals tend to lower the threshold to 55%) of the company’s income is earned or paid via cross-border transactions or the majority of the company’s assets (immovable property and high-value movable assets held for private purposes, other than cash, shares, or securities) are located in a foreign country in the preceding two years.
- Outsourced Services Criterion. The last criterion is met if the company outsources significant management (decision-making) and administration functions during the preceding two tax years.
It is important that some of the criteria are assessed retrospectively (i.e., for the past two tax periods). Therefore, assuming the proposed implementation term for the provisions of the Directive is January 1, 2024 (as currently planned), the look-back period would start as early as January 1, 2022.
The company meets the criteria – what’s next?
If a company crosses all three gateway criteria, it should be subject to reporting obligations demonstrating minimum economic substance (unless it requests for exemption if the existence of the company does not reduce the tax liability of its beneficial owner(s) or the group as a whole, of which the company is a member). In other words:
- The company has premises in the Member State where it is residents for tax purposes;
- The company has and uses at least one bank account in the EU;
- The director or the majority of the company’s full-time employees are residents for tax purposes in the Member State of residence of the company or at a reasonable distance from that Member State compatible with the proper performance of their duties, and such employees are qualified enough to carry out activities that generate relevant income for the company. Additionally, the director should have the authority to make decisions on behalf of the company, actively use these powers, and not be an employee of non-affiliated companies simultaneously.
If a company fails to provide the required information or only provides it partially and cannot rebut the presumption of not having enough economic substance by providing additional evidence, it may be considered a “shell” company.
What happens if a company is recognised as a “shell” company?
Firstly, “shell” companies would not enjoy the provisions of the EU Parent, Subsidiary, Interest and Royalties Directives, so cross-border payments of interest, royalties, and dividends to “shell” companies would, in most cases, be subject to withholding tax.
Moreover, the tax authorities would not issue a tax residence certificate to “shell” companies (or it would be issued with a special warning that it is a “shell” company), thus limiting the possibility of taking advantage of the benefits of the Double Tax Treaties, such as reduced withholding tax rates, etc.
In addition, the shareholders of the “shell” company (including individuals) would be taxed in their country of residence on the passive income of this company as if they had received it directly.
The EC proposes to include even more tax measures, including taxation of assets, effective exchange of information on “shell” companies and companies that meet the “gateway” criteria, as well as providing the EU Member States with the right to request the tax authorities of another Member State to carry out the tax audit of the company, which at the evaluation of the first Member State, does not meet the criteria of the economic substance.
Why is the Commission’s initiative relevant today?
Although the first draft Directive was published at the end of the year 2021, the EU member states have yet to reach a consensus on the provisions of the Directive. Subject to the unanimous agreement of the Member States, the draft Directive states that the provisions of the Directive will have to be transposed into national law by June 30, 2023, and apply from January 1, 2024. However, it is still unclear whether the Directive will be adopted in the near future, taking into account other significant EU and international initiatives in the field of taxation (e.g., the review of international taxation principles by the Organisation for Economic Cooperation and Development in the context of the digital economy and EU Directive 2022/2523 on ensuring a global minimum level of taxation for multinational enterprise groups and large-scale domestic groups in the Union) and their upcoming implementation by countries in their national laws.
Whatever the outcome of the EU Council’s deliberations on this proposal, there is no doubt it will influence future decisions by tax authorities implementing the provisions of national legislation, as well as future international or national legislative initiatives. This means it’s time for the companies to re-assess their role in the group and take adequate measures to manage future tax risks.
At this stage, the taxpayers should pay attention to “gateway” criteria, which, after the Directive is implemented, would be assessed for the two preceding tax periods (i.e., the existing factual circumstances may already have a decisive influence on the calculation of additional tax liabilities in 2024 or 2025). By assessing companies’ economic activities in advance, according to the criteria set out in the EC proposal and eliminating or minimizing risk factors, future tax consequences can be avoided.
What would the provisions of the Directive mean for Lithuanian companies?
Lithuanian Law on Tax Administration and Law on Corporate Income Tax already has a number of anti-avoidance provisions in place, enabling Lithuanian tax authorities to deny the application of Lithuanian participation exemption rules or any other beneficial tax treatments or exemptions in case certain transactions (including the incorporation of certain companies) were performed solely of for the main purpose of obtaining tax benefit (which, according to the national legislation, also includes the postponement of the tax liabilities). Substance over the form principle, established in the Law on Tax Administration, provides tax authorities wide opportunities to reclassify certain transactions and remove the application of various beneficial taxation rules (including those set when implementing the EU Directives). As of 2016, Lithuania established special anti-avoidance rules, removing the participation exemption rule for dividends paid to foreign shareholders that lack economic substance. And as of 2019, all beneficial treatments established in the Law on Corporate Income Tax could be denied if the companies lack economic substance.
Practical guidance on the level of economic substance sufficient for applying the participation exemption rule is still evolving. Lithuanian tax authorities had published the Official Commentary, setting up very similar criteria for evaluating economic substance as the ones in the draft of the Directive (employees, their relevant qualifications, and authority to make decisions in the name of the company, premises, active income, bank account in the country of residence of the company, and timing of establishment—close to the dividend payment—etc.). Thus, it could be expected that the Lithuanian tax authorities would refer to or actively use the criteria established in the draft Directive for determining companies lacking economic substance, even if the Member States failed to decide unanimously on the adoption of it.
Possible consequences for “shell”- qualified companies:
- Denied participation exemption – withholding taxation on dividends;
- Denied exemption rule for interest – withholding taxation on interest, paid to EEA countries;
- Denied holding exemption – taxation on capital gains of sale of shares;
- Denied exemption rule for royalties – withholding taxation on royalties paid to the EU group companies;
- Denied tax-neutral mergers – taxation of capital gains, deriving in the course of certain times of mergers.
What would the provisions of the Directive mean for Latvian companies and private individuals?
The Latvian Law on Corporate Income Tax already contains several anti-avoidance provisions that deny the application of beneficial tax treatments or exemptions in case transactions (including the incorporation of certain companies) are carried out solely to obtain tax benefits. The substance over the form principle, established in the Law on Taxes and Duties, provides tax authorities opportunities to reclassify transactions and remove the application of all beneficial taxation rules (including those set when implementing the EU Directives).
The most commonly used tax exemption by companies is the tax-free treatment of pass-through dividends, which are exempt from corporate income tax in Latvia if they are received from a payer who is a corporate income taxpayer in its country of residence, or dividends from which tax has been withheld in the country of their payment (with the exception of dividends received from a person established in low-tax countries). A similar exemption is provided in the Law on Personal Income Tax which stipulates exemption from personal income tax for dividends if corporate income tax is paid for them and received from a company registered in the EU or EEA country which is established and acts in accordance with the respective legal acts of that country.
If the payer of dividends qualified as a “shell”, it is more likely that exemptions from corporate income tax and personal income tax for received dividends would be denied, even under the current rules.
Additionally, other possible consequences dealing with the company qualified as a “shell” include:
- Denied exemption from sale of shares held more than thirty-six months;
- Denied exemption from write-offs of doubtful debts;
- Withholding tax application to management and consulting fees;
- Denied tax-neutral mergers – taxation of capital gains, deriving in the course of cross-border mergers.
At the moment of drafting this article, Latvian tax authorities have not published any guidelines on criteria for evaluating economic substance. Thus, if the Directive is adopted, tax laws change, and respective wider tax consequences are expected.
What would the provisions of the Directive mean for Estonian companies and private individuals?
The Estonian Income Tax Act already includes a number of anti-avoidance provisions, mostly transposed from the EU anti-avoidance directives, allowing the tax authority to apply what is, in effect, an economic substance rule. In particular, exemption on the redistribution of dividends received from a company lacking substance can be denied based on the existing rules.
Some of the consequences of being a “shell” undertaking or dealing with a foreign “shell” undertaking include:
- Tax treaty benefits denied on payments made to a “shell” company – making the company subject to withholding taxes in the source countries
- Denied exemption for royalties – withholding taxation of royalties paid to non-residents
- Undertaking’s income becomes taxable directly at the EU shareholder level
Estonian resident individuals who have a stake in an EU company should be mindful of the risk that, should the company prove to be a “shell”, the company’s income may be taxed as if directly accrued to the individual shareholder.
Written by Dr Aistė Medelienė, Ingūna Ābele, Kristers Zālītis, Dr Mindaugas Lukas, Rolan Jankelevitsh, Priit Raudsepp, Vytenis Čepė