María González Cuervo

Uría Menéndez, Madrid

maria.gonzalez.c@uria.com

On 22 December 2021, the European Commission published the text of a draft directive (also referred to as ‘ATAD 3’) laying down rules to prevent the misuse of shell entities for tax purposes. The applicable entities are those that lack minimum substance and do not carry out any real economic activities. In the wake of publication, doubts immediately arose as to whether ATAD 3 would ultimately make it through the European Union legislative process, which requires the unanimity of all the EU Member States, given that the European Parliament had proposed a series of non-binding amendments.

The EU Parliament ultimately approved an amended version of ATAD 3, the changes of which should not be considered as binding, but rather as recommendations. However, the EU Council will have the final say on ATAD 3’s adoption and its subsequent implementation into the domestic legislation of the EU Member States. However, there remains significant uncertainty regarding the directive’s final form.

In brief, ATAD 3 establishes rules to prevent the misuse of shell entities for tax avoidance purposes and expands the scope of EU Council Directive on administrative cooperation in the field of taxation (2011/16/EU). Its ultimate purpose is to prevent the use of conduit companies in the EU that are ostensibly engaged in an economic activity but, in reality, do not perform any economic activities and lack minimum substance. Unlike other tax measures, there is no de minimis test and, as such, the framework may potentially apply to all structures irrespective of size.

ATAD 3 is broadly inclusive and applies to all entities, regardless of their legal form, that claim to be engaged in an economic activity and are resident in an EU Member State for tax purposes and can obtain a tax residency certificate from the corresponding domestic tax authorities. A carve-out is also established for entities that are resident for tax purposes in non-Member States, as well ‘excluded entities’ (ie, specific listed companies, regulated financial entities and certain domestic holding companies). It should be taken into consideration that the exemption for entities with sufficient employees (ie, those with at least five full-time employees) has been removed from the amended version of ATAD 3. However, it is unclear whether this change will survive the legislative process.

While economic substance has been a relevant topic in recent years, ATAD 3 attempts to introduce a more prescriptive, rules-based approach to assessing an entity’s substance by creating filters to identify at-risk entities or shell entities.

In summary, ATAD 3 establishes a two-filter system to fight tax avoidance through the misuse of shell entities: (1) the ‘gateway test’ (based on, collectively considered: passive income, cross-border activity and outsourced management and administration); and (2) the ‘minimum substance test’. These tests seek to establish whether an entity has a genuine economic link with its country of residence, setting out a minimum level of activity to determine if an entity is being misused for tax avoidance purposes. It is notable that the current drafting in connection with the two-filter system includes a retrospective two-year look-back period, meaning that ATAD 3 has retroactive effects from, in principle, 1 January 2022.

Only entities that fulfil the ‘gateway test’ will be considered to be ‘at risk’ and will be obliged to meet the ‘minimum substance test’, which consists of three ‘substance indicators’ for tax purposes: the entity’s premises, bank account, and directors and employees. The draft has been published at a time when the concept of ‘substance’ has become of increasing interest to tax authorities when determining eligibility for EU directive and tax treaty benefits, and is often used as a proxy for residence and beneficial ownership considerations, despite the term ‘substance’ not being explicitly included in the tax treaties.

In practice, satisfying the substance indicator through a bank account should be straightforward, as it seems feasible for most entities. However, the current drafting is silent on bank account activity, whether a minimum number of yearly transactions is required.

Furthermore, the lack of clarity regarding the ‘premises’ and ‘qualified directors and employees’ substance indicators has created some doubt regarding their potential reach, namely, where a presence is still required, which is far removed from the digital age where more and more functions can be performed remotely.

For example, it is unclear whether the use of rented office space would meet the definition of ‘own’ premises or whether the use of premises by a group of entities would create a risk that an entity does not meet the ‘exclusive use’ requirement. However, a possible amendment could include the wording ‘premises shared with entities of the same group’, which would partially address the above issue.

Although ATAD 3 does not impose any requirements regarding the role that entities play, the only thing that matters is that they are qualified to carry out the ‘undefined’ activities. Moreover, the requirement concerning the availability of qualified directors could be problematic as director positions are often held by professional services providers that sit on several boards simultaneously or are not resident in the same Member State. ATAD 3 explicitly disallows the appointment of unqualified third-party directors who perform similar functions for other unrelated entities.

Currently, there is no standard or comprehensive definition of shell entities. However, domestic rules and case law indicate that there are several characteristics common to the definition of a shell entity, such as: a lack of substance or economic activity; a lack of physical presence; the real owner of the shell entity is unknown; and the entity is usually part of a complex group structure where the beneficial owner of the income isn’t really known. These elements point to at-risk shell entities being used for tax avoidance purposes.

It is conceivable that, within the context of the decision-making process at the EU level, the new two-filter system could serve as a general guide for defining ‘economic substance’ from a domestic tax perspective, which, in Spain, would require each entity to show that: it is directed and managed from Spain; it engages in core income-generating activities in Spain; it has ‘adequate’ staff, assets, costs and income in Spain in relation to its core income-generating activities; and the information it provides to the Spanish authorities is accurate from accounting, commercial and tax perspectives.

In Spain, the main unresolved open issue is whether the Spanish tax authorities will replace their own criteria with the requirements of ATAD 3 or whether instead they will attempt to operate with two sets of criteria. Although the number of criteria would increase, the focus on the three substance criteria established in the current draft, an entity’s premises, bank account and directors and employees, would be expanded to address other aspects (eg, such as disallowing the application of the Spanish tax regime applicable to Spanish foreign securities-holding companies, which are known as entidades de tenencia de valores extranjeros, or ‘ETVEs’).

As a result, ATAD 3 would introduce an EU-wide ‘substance test’ and would mark a significant step towards direct taxation within the EU, as it would be the first set of rules to harmonise the minimum substance criteria for tax purposes.