Goodwin Insights August 04, 2022

A New Direction for ATAD III Proposal?

Further to the request of the European Parliament for concerted EU action, the European Commission issued on 22 December 2021 a proposal for a Council Directive laying down rules to prevent the misuse of shell entities for tax purposes and amending Directive 2011/16/EU (hereafter referred to as “ATAD III proposal” or simply “directive”).

More recently, the Committee on Economic and Monetary Affairs has issued a draft report on the said ATAD III proposal (simply the “Draft Report”). This is not yet the final version of the directive, but given the importance of this preliminary step in the legislative process, the amendments suggested therein are significant indicators to the market on the direction being taken.

ATAD III Proposal

ATAD III proposal was born at the request of the European Parliament for EU coordinated action on the misuse of shell entities for tax purposes and, more broadly, from civil society and several member states further to media revelations. As such, ATAD III proposal aims to address this subject as the leading example on the matter.

Broadly speaking, the term “shell entity” refers to entities lacking minimum economic substance, that do not perform any actual economic activity, and that can be misused for tax avoidance or evasion purposes. The aim of ATAD III proposal is thus clear on a rather intricate matter - to lay down a common framework to tackle the misuse of shell entities for tax purposes.1

In essence, ATAD III proposal lays down conditions known as “gateways” that are intended to identify entities that may be considered empty shells. The first two gateways are met if:

  1. The threshold for relevant income (mobile and passive income or from insurance or banking activities) is reached; and
  2. The entity is engaged in cross-border activity.

The latter being measured again by reference to precise thresholds concerning the book value of specific assets located abroad and relevant income arising from cross-border transactions.

The third gateway is the one involving more discretion in its interpretation as it refers to the outsourcing of the administration of day-to-day operations and decision making on significant functions without precise references or thresholds.

Should all three gateways be met, the entity should declare in its tax return whether they meet the minimum substance indicators and provide documentary evidence in this respect (e.g., office space, bank account, details on board composition, qualifications, tax residence, as well as their employees).

The undertaking will be presumed to have the minimum substance for that tax year if the minimum substance indicators are met and adequate evidence is provided. The undertaking can also apply for an exemption from these obligations by proving that its interposition does not reduce the tax liability of its beneficial owner or the group, as the case may be.

If not, and if no additional information is provided to evidence the undertaking’s substance and economic activity, the entity may ultimately be denied access to treaty relief and EU directives and trigger withholding tax on payments and taxation of its shareholder on a look-through basis.

It is important to note that the directive provides a carve-out for entities considered  low-risk, as they are already under significant scrutiny (this is the case, for example, of companies listed in regulated markets and regulated financial undertakings).

Non-compliance with the obligations set out in the directive will give rise to penalties of at least 5% of the entity’s turnover in the relevant tax year.

The Draft Report

The rapporteur set out three main objectives for the Draft Report:

  1. Guarantee privacy and data protection;
  2. Safeguard a level playing field for EU companies; and
  3. Avoid excessive administrative burden and compliance costs for operators.

In its explanatory statement the rapporteur acknowledges the importance of differentiating between the legitimate use of specific legal structures for investments, compliance, and cross-border operations from the misuse for tax avoidance and aggressive tax planning.

One positive sign in this direction is already given in the amendments to the recital. While defining shell entities as companies with minimal economic substance, the rapporteur acknowledges their use for legitimate business purposes. It is further conceded that, to preserve the competitiveness of the European undertakings, the obligations under the directive should be proportionate, effective, and neutral from a tax point of view, which demonstrates a better understanding of certain industries such as the investment fund industry.

With regards to the core measures, the amendments are also welcomed. 

The scope of the reporting obligation is mostly reduced by increasing (or reducing, as the case may be) the gateway thresholds a shell entity would need to meet to trigger the reporting obligation. The scope of the third gateway is also further reduced as now the outsourcing of the administration of day-to-day operations and decision making on significant functions is only met if it is to an entity that is not an associated enterprise within the same jurisdiction as the reporting undertaking.

And more importantly, entities owned by regulated financial undertakings and which have as their objective the holding of assets or investment of funds are now also clearly mentioned in the carve-out provision.

One other key amendment was the postponement of the entry into effect of the directive by one year (i.e. to 1 January 2025). This is most welcomed given that the previous timeline with the “look-back” period of two years was creating a retroactive application of the measures.

Finally, the penalty threshold for non-compliance was reduced to at least 2.5% of the undertaking’s turnover (instead of the 5% previously prescribed).

Next Steps

ATAD III proposal is currently under consultation procedure and awaits the committee decision. The vote is scheduled for 17 November 2022 and plenary session for 12 December 2022.

The proposed amendments in the Draft Report are an important step towards a more realistic approach to minimum substance and we hope that further steps in this direction will be taken during the legislative procedure before the final adoption of the directive.

[1] The assessment of tax purpose is of complex, and too often subjective nature, as any exercise is when ascertaining someone’s motivations and intentions.