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Developments on the EU’s proposed unshell directive

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Mélanie Delvaux and Jean-Michel Henry of Deloitte Luxembourg give an update on the EU’s proposal for a directive to prevent shell companies being used to evade or avoid tax, and how the regulations could affect companies.

On December 22 2021, the European Commission published a proposal for an “unshell” directive intended to prevent the misuse of shell entities for tax purposes. It would target passive undertakings that are tax resident in an EU member state and that do not conduct economic activity because they presumably do not have minimum substance.

Certain undertakings would be explicitly excluded from the directive’s scope under specific conditions (such as companies with a transferable security admitted for trading or those listed on a regulated market).

The identification of undertakings within scope would be based on three cumulative criteria (“gateways”) covering the preceding two tax years and consisting of:

  1. A passive element (more than 75% of the undertaking’s revenue);

  2. A cross-border element; and

  3. An outsourcing element.

Only if an undertaking crosses all three gateways would it be considered “at risk” and subject to reporting obligations.

An undertaking crossing all three gateways would have to perform a “substance” test on its tax return, including reporting information on its own premises, its active EU bank account(s), and its director(s) or full-time employees.

If the substance test is not met, the undertaking would be presumed to be a “shell” and, in addition to reporting obligations, the following would apply:

  1. No certificate of tax residency would be granted by local tax authorities (or it would be granted with a specific warning);

  2. The entity would not have access to the EU parent-subsidiary and interest-royalty directives or income tax treaties; and

  3. The tax authorities of EU member states would exchange information on the undertaking (this would also apply to undertakings “at risk” even if they do not fail the substance test).

These conditions could result in the company being subject to local withholding tax in the source country or in the taxation of the undertaking’s income at the EU shareholder level.

Unlike the proposed pillar two directive outlining a global minimum tax, there would be no minimum revenue threshold for the application of these rules. However, an undertaking could be exempt in the absence of tax benefits for itself or its group, and it could also rebut the presumption that it is a shell.

Status of the proposal

The draft directive still needs to be unanimously agreed by all EU member states. If approved, the directive’s provisions would likely be transposed into each EU local legislation by June 30 2023, and its provisions would be effective from January 1 2024.

Further to public consultation and the positions on the draft directive taken by the Czech Republic and Sweden—as well as the draft comments recently proposed by the EU Parliament’s Committee on Economic and Monetary Affairs—some of the draft directive’s provisions and definitions could be amended and further clarified (and then approved by the EU Council). Entry into force could therefore be postponed until January 1 2025.

These additional discussions represent an opportunity to address issues where taxpayers seek clarification, notably regarding the following two issues:

  • Practical reporting issues and interaction between EU member states

The draft directive proposes that reporting on substance and testing would need to be done through and on the basis of a taxpayer’s tax return. This raises practical questions regarding how an undertaking could achieve certainty about its position during financial year N (including whether it could receive a tax residency certificate under the proposed rules) in a situation where the reporting on substance and assessment would be done only in financial year N+1 (the year in which the tax return is filed).

There are also practical questions around how the tax authorities of the EU member state where an undertaking’s shareholder is located should proceed if foreign tax authorities have not completed their assessment of whether the undertaking’s EU subsidiaries qualify for residency certificates. These certificates would be needed in advance of any cross-border EU payments.

  • Timeframe for assessments

It is unclear whether the two-year look-back period for gateway assessments (placing the year 2022 in scope, assuming an effective date of January 1 2024) will be maintained. This look-back period creates a risk of some legal uncertainty for taxpayers because the directive is still in draft.

Separately, the EU Parliament’s Committee on Economic and Monetary Affairs has proposed that outsourcing to an associated enterprise within the same jurisdiction as the undertaking would not be considered outsourcing for the purposes of the gateway tests.

This could be seen as a positive development and welcomed by taxpayers who must appropriately define the concept of associated enterprises to align with business model realities and their legal structure. However, this must still be approved by the EU Council to become part of the directive.

Next steps

EU taxpayers should follow legislative developments and perform a preliminary ‘gap’ assessment to see where they stand in light of the draft directive. The situation during the 2022 financial year could already be decisive. Depending on the facts, an undertaking could be excluded or carved out in various situations, or the practical impact of the proposed rules could be limited only to additional reporting, without necessarily leading to adverse tax consequences.

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