Unshell – EU Commission's new initiative to tackle the misuse of shell entities for tax purposes

Scope

The draft Directive sets out a seven step minimum substance test to determine whether an entity is to be regarded as a 'shell.' It applies to all undertakings resident in a Member State, regardless of their legal form. However entities that meet any one of the following criteria is exempt from the Minimum Substance Test:

• Any company with a security listed on a regulated market,
• An entity that is a regulated financial undertaking,
• An entity that holds shares in an operational business located in the same Member State of the entity or,
• An entity with at least five full-time employees carrying out the income generating activities of the entity.

Minimum Substance Test

1. Undertakings that should report: The first step establishes three "gateway" criteria which are considered to be indicators of low-substance. These are:
   • 75% of the entity's income is "passive income" (defined in the draft Directive) over a two-year lookback period;
   • 60% of the book value of entity's assets are located outside the Member State of which it is resident or 60% of its income is from outside the Member State, again over a two-year lookback period;
   • The administration of day-to-day functions and decision-making is outsourced.
2. Reporting: If all three gateway criteria from Step 1 are passed, specific information must be reported in the entity's tax return including whether it has:
   • A premises available for its exclusive use
   • It's own active EU bank account
   • A qualified director resident in the same Member State or sufficiently close to that State who is dedicated to its activities. As an alternative to the director, an entity may demonstrate that the majority of full-time employees are resident or close to the State and are qualified and engaged in the income generating activities of the company.
     
     The undertaking must provide documentary evidence to support the above information.
3. Tax authorities decision: While the entity must declare whether it meets the indicators above, the relevant tax authority will have the final say in determining whether the indicators are met or not. If the indicators are met, there is a presumption that the entity is not a 'shell.' The backup documentation provided will be key in this section.
4. If an entity is considered a 'shell' by the tax authority, and thereby subject to the consequences set out in Step 6 below, the burden of proof to rebut this classification is on the entity to prove it has minimum substance or it is not misused for tax purposes. Information to be provided in making its case may include the reasons for setting up the entity, the resources it has at hand and proof that key decisions occur in the Member State it is resident in. 
   
   A positive rebuttal is valid up to 6 years in total, provided the entity's facts and circumstances don't change.
5. Exemption for lack of tax motives: If an entity crosses the gateway criteria in Step 1 but believes it meets the required indicators in Step 2, it can apply for an exemption from the obligations set out in the draft Directive. The entity must prove that it has been set up for genuine business reasons and does not create a tax benefit for itself, its beneficial owners or the group of companies which it is a part of.
   
   This exemption would be valid up to 6 years in total, provided the entity's facts and circumstances don't change.
6. Consequences: If an entity is considered a shell it may suffer the following consequences:
   • It will not be issued a tax residence certificate by the Member State that it is considered resident in or the certificate will come with a warning to prevent its use for claiming relief from double taxation;
   • The entity will be denied relief under measures designed to prevent double taxation, meaning its income may be taxable in both the Member State it is resident in and other Member States;
   • The proposed Directive plans to introduce a CFC-type taxing right, which would give the entity's shareholders the right to tax "relevant" income of the shell entity, less any tax paid by the shell itself;
   • The reallocation of taxing rights should only affect EU Member States and not entities based in third countries. Existing double tax agreements would still apply in situations involving third countries.
7. Exchange of information: The final step will require Member States to share data from Steps 1, 2, 4 and 5 to a central directory. They will be required to report within 30 days of:
   • Receiving a tax return,
   • Approving a rebuttal or an exemption or;
   • Following an audit into an entity under the provisions of the proposed Directive.

Penalties

A minimum 5% penalty on an entity's turnover will apply if an entity is found to be non-compliant with the reporting requirements set out above.

For further detail on the above, check out our Tax Policy Alert published on 23 December 2021.

The key action to take now: Identify any potential at-risk companies

We strongly recommend that all in-scope businesses begin to examine entities within their group structure that may fall under the provisions set out above. Where an entity will not meet the exemption criteria and subsequently is considered to be a shell entity under the minimum substance test, it may be denied key tax benefits under double taxation agreements. This may result in additional tax becoming payable, as well as additional administrative burdens for the business.

If the proposed Directive passes through the legislative process as expected in 2022, the rules should come into effect from 1 January 2024. Although this is an ambitious timeline given the packed legislative agenda for 2022 in the EU, it nevertheless gives companies and individuals ample time to identify any companies that may be considered a 'shell' and consider possible actions to minimise the potential tax impact.

We are here to help you

We can assist you in this process of identifying any at-risk entities and help you with your approach to dealing with any potential adverse tax implications that may arise. Please reach out to your usual PwC contact today who will have the knowledge of your group structure needed to support you in understanding the potential implication of these new rules.