European Commission presented a directive on preventing shell companies from misusing their structure for tax purposes (‘Unshell’)
While shell companies – company entities that have no or minimal economic activity – can serve useful commercial and business functions, they are sometimes abused by companies or individuals for aggressive tax planning or tax evasion.
To ensure sustainable public finances under the exceptional circumstances imposed by the COVID-19 pandemic, in December 2021 the European Commission presented a directive on preventing shell companies from misusing their structure for tax purposes (‘Unshell’).
The proposal introduces a ‘filtering’ system for EU company entities, which will have to pass a series of gateways, relating to income, staff and premises, to ensure there is sufficient ‘substance’ to the entity. Those entities that are deemed to be lacking in substance are presumed to be ‘shell companies’ and, if they are unable to rebut this presumption through additional evidence regarding the commercial, non-tax rationale of the entity, they will lose any tax advantages granted through bilateral tax treaties or EU directives, thereby discouraging their use.
Who does the new Directive affect?
For the time being, only companies (regardless of their legal form) based in the EU are affected by the Directive. However, the EU Commission will already present a proposal on the treatment of shell companies domiciled outside the EU later this year. The Directive does not provide for any minimum criteria; but rather exempts certain types of companies, in particular (i) certain regulated financial companies (e.g. funds), (ii) companies with transferable securities listed on a regulated market (iii) and companies employing at least five full-time employees who are engaged in the generation of the relevant income (see below) as well as (iv) companies with holding activities which have their registered office in the same member state as its shareholder or as the ultimate parent entity (UPE).
The Directive is scheduled to enter into force on January 1, 2024. However, the question of whether a company is a shell company will be based on the substance existing in the country of domicile in 2022 and 2023. We therefore recommend that companies with their registered office or group companies in the EU comply with the criteria of the new Directive as early as 2022.
How is it determined if a company is a shell company?
The procedure is carried out in two stages. In a first step, it is established whether the company fulfills three criteria, so-called gateways (gateway test). In simplified terms, the gateways are as follows:
1. More than 75% of the company’s income is derived from so-called relevant income. Relevant income includes income from passive income (interests, dividends, royalties, income from disposal of shares, etc.), income from immovable assets or income from other movable assets (other than cash, shares or securities) with a book value exceeding one million euros held for private purposes; and
2. At least 60% of the relevant income is derived from cross-border activities or at least 60% of the assets are invested in real estate or tangible assets outside the country of domicile; and
3. Day-to-day operations and decision-making on key issues are outsourced to third parties.
If all three criteria are met, there is a rebuttable presumption that the company is a company without substance (shell company). In this case, the company concerned must, in principle, provide evidence of its substance each year as part of its tax return. The presumption that the company is a shell company is rebutted if the company cumulatively meets the following three substance criteria:
1. The company has its own offices in the country of domicile or has premises available for exclusive use; and
2. The company has at least one active bank account in the EU; and
3. The company meets at least one of the following two conditions (including subconditions):
a. At least one of the directors of the company
Is resident or lives close to the company’s headquarters (commuting distance); and
Is qualified and empowered to make major business decisions; and
Makes active, independent, and regular use of this authority; and
Is not an employee of an independent third party company and also does not perform the function of director or a similar function at an independent third party company.
b. The majority of the company’s employees are residents of the country of domicile or live within commuting distance of the company’s headquarters and are qualified to carry out the activities needed to generate the relevant income
If the aforementioned substance criteria are not met, the company is generally classified as a shell company. However, the Directive explicitly provides for the possibility of a counterstatement. In this case, the company must be able to prove in the specific individual case that it is pursuing an economic (non-tax) purpose, for the achievement of which, for example, no own offices, bank accounts or directors are necessary. Also in the context of a counterstatement, it can be asserted that no tax advantage results from the interposition of the company. The EU member state must then examine whether it wants to maintain the qualification as a shell company despite the counterstatement. Due to the substance criteria clearly stated in the Directive, we assume that a successful counter statement will only be possible in very few and specific cases.
What are the consequences of classification as a shell company?
The taxation of the company in the state of residence itself remains unchanged. However, if a company is classified as a shell company, the state of residence is obliged either to not issue a residence certificate or to attach a warning to this residence certificate. As a result, the tax exemptions provided for in double taxation agreements (DTAs) or in EU treaties, such as the Parent-Subsidiary Directive, are no longer granted by the other EU member states. In particular, this means that these member states will no longer grant the shell company relief from withholding tax on dividend, interest or royalty payments. In addition, if the owners of the company are resident in an EU member state, that state will assess the relevant income of the company in accordance with the national tax law as if the income had accrued directly to the owners. In this context, any taxes already paid in the country of residence of the company will be credited and DTAs between the source country and the country of residence of the (EU) owners will also remain applicable according to the guidelines. If the owners are resident in a third country, e.g. Switzerland, there will be no direct taxation in the owners’ income, as the Directive is not applied by the third countries.
In principle, taxation in the third countries will therefore only take place when the funds are distributed to the owners. In our opinion, however, it is highly unlikely that the owners will then be able to claim back or have credited the taxes paid in the residence country of the shell company or in the source country.
In addition, member states may provide for fines of at least 5% of the companies’ annual turnover if they do not comply with the provisions of the Directive. Data on companies with little substance, i.e. shell companies and those for which there is a presumption of lack of substance based on the gateway test, will be exchanged among EU states.