Tax substance: uncertainty is over with EU Commission providing objective criteria - Immediate action needed

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The European Commission released last month a proposal for a directive to prevent the use of tax shells.

Is this good news?

Essentially yes. With a set of harmonized and objective criteria, tax uncertainty created by inconsistent and highly volatile substance requirements across EU member states is over.

But the bad news is that the directive should enter into force on January 1, 2024, with a look back over 2022 and 2023 to assess new substance criteria.

As a result, groups need to take immediate action and review their structure charts to ensure that new directive criteria are met by their holding companies as from now on.

What are the tax consequences?

Shell entities will no longer be eligible to treaty benefits and to favorable provisions of the EU directives, notably on reduction or exemption of withholding taxes on dividend and other passive income.

Moreover, certificates of tax residency for use in another jurisdiction will be disregarded.

What are the new substance criteria?

First, the directive creates a presumption of lack of substance when three conditions are met:

  • Over 75% of the revenue accrued is passive income or income from immovable property or movable property held for private purposes ("relevant income");
  • 60% of the relevant income is cross-border; and
  • Day-to-day operations and decision-making on significant issues have been outsourced to third parties.

Decision making on significant issues and third parties arrangements need to be carefully audited and monitored. 

Deemed shell entities can challenge the presumption by providing evidence of their substance with their tax returns each year:

  • The company has its own offices in the Member State, or premises for its exclusive use;
  • The company has at least one active bank account in the Member State; and
  • The company has directors and employees with effective roles in the Member State where they are established.

Effective roles and residency are critical.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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