Background

A draft EU Council directive, known as ATAD 3, was issued by the European Commission as a proposal at the end of last year. The directive is aimed at countering the misuse of 'shell' entities and could impose adverse tax and reporting provisions on EU legal entities which do not meet minimal substance and economic activity requirements. Although there remains some uncertainty as to the final form of the directive and how it will apply to international fund structures, it is highly likely that the directive will be adopted in some form and urgent consideration should therefore be given as to whether intermediate and subsidiary legal entities typically involved in such structures could be impacted by these provisions.

Although the intention is for Member States to pass domestic legislation to implement the directive by the middle of 2023 with a view to legislation becoming effective in January 2024, as noted below, it may be necessary to start taking steps now to ensure relevant fund companies are not caught by the directive.

Tax and reporting consequences of being a shell entity

If the Directive applies to an entity and the entity does not meet the minimum substance requirements or benefit from an exemption, various tax-related consequences may follow:

• The entity may not be entitled to benefit from any double tax treaties, whether relating to the EU or with respect to third countries. The home Member State would be required not to issue a certificate of residency or if a certificate is issued, it should refer to the lack of substance
• It will not be able to benefit from EU tax directives like the parent-subsidiary directive or the interest and royalties directive.
• EU shareholders will be taxed broadly as if the shell entity was ignored in relation to income arising from underlying assets of the shell entity.
• EU jurisdictions where the underlying assets of the shell entity are located can impose withholding taxes on income flows to the shell entity as if paid directly to the shareholders of the shell entity.

In a sense, the effect of the consequences may be to treat the entity similarly to a disregarded entity, as commonly encountered in a U.S. tax context.

As a result of the reporting requirements imposed by the directive, all Member States will automatically have access to information on shell entities without the need to request the information specifically. Individual Member States will also be able to request tax audits from particular shell entities established in that Member State if they have grounds to suspect that the entity might be lacking the requisite substance.

The directive also provides for penalties to be levied of at least five percent of the entities’ turnover in the relevant tax year in circumstances where there is a failure of reporting.

Gateway test

Unless an exemption or exclusion applies, legal entities that satisfy each of the following ‘gateway tests’ will be required to report under the directive:

(i) Where 75 percent of their income is passive income such as interest, royalties, dividends, rental income and gains derived from the disposal of shares;

(ii) Where they are engaged in cross-border activity such that more than 60 percent of their income is earned or paid by cross-border transactions or more than 60 percent of the value of their assets are located outside the relevant Member State; and

(iii) Where in the preceding two years, the undertaking allowed the administration of day-to-day operations and the decision-making on significant functions to be outsourced.

Reporting requirements

If an entity meets each of the gateway tests and cannot take advantage of an exemption, it is required to report to its local tax authority as to whether it meets each of the following minimum substance requirements:

(i) The entity has dedicated premises available to it to undertake its business;

(ii) The entity has an EU bank account; and

(iii) The entity has at least one qualified authorised director who is resident for tax purposes in the relevant jurisdiction of the entity or otherwise sufficiently close to that jurisdiction in order to carry out his or her duties adequately (e.g. for Luxembourg, in the Great Region). That director must not also be a director of any unconnected enterprise. Alternatively, the undertaking must have a sufficient number of employees engaged with its core income-generating activity who are resident in the relevant EU jurisdiction or sufficiently close to it to carry out their duties adequately.

Presumption of guilt

If an entity that is required to report is unable to evidence that it meets each of the three minimum substance requirements noted above there is a presumption that the adverse tax consequences should apply to it. However, it is possible to counter that presumption if sufficient evidence can be produced to show that there are valid commercial reasons for the existence of the entity. There is also a further exemption if it can be shown that no tax benefit is derived from the use of the entity in the structure.

Key exemptions

Crucially, it is recognised that certain types of entities should be excluded from the tax reporting and adverse tax measures proposed by the directive. In particular, these exclusions include regulated financial undertakings such as alternative investment funds managed by an alternative investment fund, UCITS, alternative investment fund management entities and EU securitisation special purpose entities. However, as drafted the exemption applies only to the regulated entities themselves. We understand that industry bodies have made representations to the effect that this exemption should extend to investment subsidiaries of alternative investment funds but it remains uncertain if any extension will be agreed. In addition, companies which have a transferable security (whether equity or debt) admitted to trading on a regulated EU market or EU multilateral trading facility are excluded. Further, undertakings with five full-time employees or members of staff exclusively carrying on the activities generated by the entity are excluded.

Comment

It will be important for funds and investment fund managers to review their fund structures in order to assess whether companies or other entities in those structures might be within the ambit of the draft directive. Ideally, it should be possible for some entities to fall within the key exemptions referred to above. However, in other cases, perhaps with intermediate or subsidiary companies in private equity or debt fund structures there may be a need to consider these tests more carefully. Furthermore, there may be an opportunity to boost the substance of entities and to also begin thinking about how these rules might impact the creation of new fund structures.

It is important to note that some tests are applied on a two-year look-back basis which means implementation from 1 January 2024 would look back to what is happening now. This places funds and investment fund managers in the difficult position of having to assess and potentially amend existing structures by reference to rules which are not yet in force and the details of which remain uncertain.

These rules only impact EU entities (albeit that the EU has already indicated that it intends to propose a further directive to address non-EU shell entities). Therefore, it may be worth thinking about creating non-EU intermediate companies as an alternative to an EU entity, particularly in fund structures that focus on non-EU assets or with non-EU investors. This might, for example, give a boost to the use of UK entities and the new UK asset holding company vehicle to be introduced from April 2022.