Overview of the Unshell Directive – ATAD 3 proposal and questions raised

June 2022 | EXPERT BRIEFING | CORPORATE TAX

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On 22 December 2021, the European Commission published a proposal for a directive known as the ‘Unshell Directive’, which aims to put an end to intermediary companies that lack a minimum economic substance (known as ‘shell entities’ or ‘letterbox entities’) in the European Union (EU) and thus, discourage their use for tax avoidance or aggressive tax planning purposes. To this end, the proposal provides that EU entities considered shell entities will be disregarded for cross-border tax purposes.

The proposal establishes a mechanism for identifying shell entities and regulates tax consequences arising from this qualification. However, this identification process raises a number of questions due to its complexity. Moreover, doubts also arise when determining the taxation of income paid through shell entities, particularly where entities resident in third countries are involved as payors or shareholders.

The Unshell Directive, if adopted, must be transposed into national laws by 30 June 2023 and its entry into force is scheduled for 1 January 2024, but with existing substance data from January 2022, which means that it will have a certain retroactive effect that obliges a review of existing structures and strengthening them, if the minimum threshold of substance set by the proposal is not reached.

Identifying ‘shell entities’

In order to assist national tax authorities in detecting shell entities that exist merely on paper, the proposal establishes three “objective indicators”, relating to the income or assets and the administration and decision making of the entities under analysis, which have to be cumulatively met to be preliminarily deemed a shell entity.

The first indicator is met if more than 75 percent of the entity’s overall revenues in the previous two tax years is income not derived from the entity’s business activity (i.e., passive income, including, among others, interest, royalties or dividends (Relevant Income)) or if more than 75 percent of the entity’s assets are real estate property or other private property of particularly high value.

The second indicator requires a cross-border element, and will be satisfied if at least 60 percent of the entity’s income is earned or paid out via cross-border transactions or if more than 60 percent of the entity’s assets are located abroad.

The third indicator focuses on whether the entity’s decision making and administration are performed in-house or are outsourced, and will be met if such services are outsourced.

What happens if an entity meets all three objective indicators? Entities that comply with the three objective indicators must report through their annual tax return certain additional information indicative of their substance (however, certain entities may be granted an exemption from these reporting obligations, but only to the extent that their existence does not reduce the tax liability of their beneficial owners or of the group, as a whole, of which the entity is a member. This exemption may initially only be granted for a maximum of one year, after which it can be extended for a maximum of five years).

Minimum substance indicators. The information indicative of substance to be reported by non-exempt entities complying with the three objective indicators relates to the premises available for their exclusive use, their bank accounts, or the tax residence and qualification of their directors and employees. These are the so-called minimum substance indicators.

What happens if an entity fails to comply with at least one of the minimum substance indicators? If an entity fails to comply with at least one of the minimum substance indicators, then it will be deemed to be a shell entity. However, it can rebut this presumption by providing additional supporting evidence of the commercial rationale behind the establishment of the entity, information about the employee profiles and concrete evidence that decision making concerning the activity generating the Relevant Income takes place in the entity’s member state.

Carve outs. It should be noted that the proposal includes a list of excluded entities (i.e., entities falling outside the scope of the Unshell Directive), among which are regulated financial entities, which in turn include, among others: (i) alternative investment funds and their managers; (ii) undertakings for the collective investment in transferable securities (UCITS) and their management companies; and (iii) pension institutions operating pension schemes which are considered to be social security schemes.

However, it should be made clear that the exclusion applicable to funds and managers is applicable to these entities, but not to their investees.

Other excluded entities are listed entities as well as entities with at least five full-time employees or staff members exclusively carrying out activities generating the Relevant Income.

Consequences of shell entity status

If an EU entity qualifies as a shell entity, by virtue of the above, it will not be eligible for the tax benefits of the network of double tax treaties signed by its member state of residence, nor will it qualify for the application of the Parent-Subsidiary Directive or the Interest and Royalties Directive.

The member state of the shell entity will be required to either: (i) refuse to grant a tax residence certificate for the shell entity; or (ii) grant a tax residence certificate for the shell entity stipulating the denial of tax benefits.

The shell entity will continue to be resident for tax purposes in the respective member state and will have to fulfil its relevant formal and material tax obligations.

The member state where shareholders of the shell entity have their tax residence will be required to tax the income accruing to the shell entity, or certain assets held by it, as if it had accrued in the hands of the shareholders directly, or as if the assets were owned directly by the shell entity’s shareholders.

The source member state will be required to ignore double tax treaties concluded with the member state of residence of the ‘shell entity’ and will have to deny the advantages of certain EU tax directives.

Exchange of information

Another relevant aspect of the proposal to be taken into account is the amendment it introduces into the Directive on administrative cooperation in the field of taxation (DAC) to oblige member states to automatically exchange information on entities falling within the scope of the Unshell Directive, irrespective of whether or not they finally qualify as shell entities.

The information to be exchanged will concern information received on minimum substance indicators, rebuttable presumptions, exemptions granted and the outcome of tax audits carried out where it is concluded that an entity does not meet the minimum substance indicators.

Controversial issues

The content of the current text of the proposal is complex and many aspects have not been developed further as necessary. But first and foremost, it is worth wondering whether it is really necessary to add another layer of control after having implemented a general anti-abuse rule (GAAR) in the EU, a principal purpose test (PPT) clause in many bilateral tax treaties, the DAC6 reporting obligations on aggressive tax schemes, and when we are on the verge of implementing Pillar 2 and public country-by-country (CbC) reporting obligations.

Moreover, a number of practical interpretative doubts arise regarding, among others, objective indicators, minimum substance indicators and excluded entities.

In relation to objective indicators, it is not clear whether outsourcing administration to another group entity (resident in the EU or even in the same member state as the entity under analysis) or to the asset manager in the case of the corporate portfolio of investment funds, would qualify as an objective indicator or what would happen if the entity only outsourced administration, not decision making. It is also unclear how the two-year lookback principle will be applied.

As regards indicators of minimum substance, doubts arise as to premises that are shared by several entities of the same group or under common management that are resident in the same member state, employees performing work for more than one group entity or portfolio entity of a fund under any kind of cost-sharing agreement, and the criteria that has to be followed to consider an employee or director as suitably qualified.

Regarding excluded entities, doubts also arise in relation to hybrid entities where they are considered to be excluded entities in one member state, but not in another.

As far as source state taxation, it is unclear, in real estate structures, whether the state where the property owned by the shell entity is located should tax the real estate income taking into account any related expenses, or whether it should instead tax the gross real estate income, when the shareholder of the shell entity is resident in a third country.

Another controversial issue concerns how third countries will deal with the tax consequences derived from the qualification of an entity as a shell entity in the EU. It is unclear whether they will apply the double tax treaties signed with the state of residence of the shell entities, or none at all.

Final remarks

The Unshell Directive, if finally adopted, will greatly affect holding structures in the EU. It is therefore reasonable to wonder whether there will be opposition to this proposal by certain member states and what the final outcome will look like after the technical discussions that are taking place at the moment.

It is also important to point out that a number of questions are still open, and many interpretative doubts exist, so there is a need for a common and coordinated interpretation between member states which goes much further than the text of the directive as disclosed.

Finally, it is worth noting that if the Unshell Directive is adopted, many taxpayers’ formal obligations will increase with additional reporting obligations. This, let us not forget, entails an additional tax burden above the tax compliance obligations arising from the anti-abuse legislation recently or soon to be approved in the coming years.

Eduardo Gracia is practice group head of tax and Lorena Viñas is a senior tax expertise lawyer at Ashurst. Mr Gracia can be contacted on +34 91 364 9854 or by email: eduardo.gracia@ashurst.com. Ms Viñas can be contacted on +34 91 364 9417 or by email: lorena.vinas@ashurst.com.

Eduardo Gracia and Lorena Viñas

Ashurst