On 22 December 2021, the European Commission published its proposal for a “Council Directive laying down rules to prevent the misuse of shell entities for tax purposes and amending Directive 2011/16/EU”. This proposal (commonly referred to as “ATAD 3”) is the Commission’s way of realising its stated intention to “further step up the fight against the abusive use of shell companies – i.e. companies with no or minimal substantial presence and real economic activity –” in order to “neutralise [their] misuse […] for tax purposes.”

The Commission was prompted to take action in this respect by revelations published by more than one consortium of journalists^[1] highlighting the issue and forcing the Commission to acknowledge it as something of a blind spot in its prolific anti-abuse legislation. Hence this Directive.

Essentially, the proposed Directive sets out conditions (referred to as “gateways”) to identify companies that may be considered empty shells. These include a lack of adequate own resources for the company’s activity and the holding of financial or investment assets as the company’s primary object. Any company within the EU matching this definition will be presumed a shell.

It is clear what the Commission is trying to achieve, but this proposal represents a major about-turn in approach. Existing measures to rein in aggressive tax planning, introduced in connection with anti-abuse clauses, centred on schemes set up primarily (or essentially) for tax purposes – a rather subjective criterion that could only be verified by delving deep into the subject’s motivations and intentions. But the minimum substance indicators in the proposed Directive are much more objective.

On 12 May 2022, the European Parliament’s Committee on Economic and Monetary Affairs submitted its report on the proposed Directive, which contained a number of amendments. The most significant of these was as regards the date of its entry into effect – pushed back from 1 January 2024 to 1 January 2025. In that the substance indicators are to be assessed over a two-year period, groups will need to start factoring the Directive in to their decision-making by 1 January 2023 at the latest.

Holding companies are evidently the primary target of the proposed Directive. To be taken into account for the purposes of direct corporate taxation, holdings must either show that they are not in fact a shell company or else seek confirmation from their tax authority that they are exempt from the obligations of the Directive.

The proposal stipulates that companies deemed to be shells will be denied the withholding tax exemptions available under the Parent-Subsidiary and Interest and Royalty Directives, as well as any treaty benefits available under a tax treaty between two EU Member States.

In practice, the impact of the Directive will vary according to whether or not the payer of the income, the shell and its shareholder are all established in the EU.

If all three are EU-based, then the Directive will have three main consequences:

• the State in which the shell is tax-resident will no longer be allowed to issue a tax residency certificate for the shell (or else must include a statement on the certificate indicating that the shell is not eligible for Directive or treaty benefits);
• the source State for any income flows to the shell that would normally be exempt from withholding tax under a Directive must disregard said Directive, as well as any tax treaty with the shell’s State of tax residence; and
• the shareholder’s State of tax residence must tax the shell’s income as if it had directly accrued to the shareholder, deducting any tax paid by the shell in its own State of residence.

If either the shell’s shareholder or the payer of the income is resident in a non-EU State (i.e. a third country), then the proposed Directive stipulates that the shell is to be disregarded, entailing the following consequences:

• when the payer is resident in a third country, the shareholder’s Member State of residence must treat all of the shell’s income as if it had directly accrued to the shareholder, without prejudice to either the tax treaty in force with the payer’s State of residence or the deduction of the corporation tax paid by the shell in its State of residence;
• when the shell’s shareholder is resident in a third country, the payer’s Member State of residence must levy withholding tax in accordance with its national law, without prejudice to the tax treaty in force with the shareholder’s State of residence.

The ensuing rise in tripartite situations and the absence of any requirement for the shell’s State of tax residence to recognise it as a pass-through entity will in many cases result in multiple taxation of the same income, raising all sorts of complex new questions on exactly which tax treaties should apply and how. To answer these questions in France, we must look to the landmark ruling handed down by the Conseil d’État (France’s highest administrative court) on 20 May 2022. The Court held that when French-source income is paid to an entity that is not the beneficial owner, the treaty applicable is the one between France and the beneficial owner’s State of tax residence, even when the immediate recipient of the payment is resident in a different State[2]. This ruling should clarify which treaty French-resident taxpayers can rely on in situations where, under the proposed Directive, an interposed entity would be deemed not to be the beneficial owner of a given income flow.

To facilitate the “unshelling” of the EU, the proposed Directive also includes an amendment to Directive 2011/16/EU, extending the automatic exchange of information to include entities that could potentially be deemed shell companies under the proposal.

This ushers in a restriction on the freedoms of movement protected by the TFEU, under cover of addressing the misuse of shells. Indeed, contrary to the usual legal reasoning in respect of these freedoms, the presumption of misuse under the proposed Directive:

-        is specific to intra-EU operations;

-        does not apply in the absence of any cross-border tax consequences, which will result in different assessments of “substance”, depending on whether domestic or EU law applies;

-         does not refer to the notion of an “artificial arrangement set up to circumvent tax law” – where the CJEU allows for certain restrictions on freedoms of movement[3] – being instead presented in connection with the notion of beneficial owner, but without actually integrating the condition of a necessary “correlation between the activities apparently carried on by the CFC and the extent to which it physically exists in terms of premises, staff and equipment”[4]; an entity could be disregarded when it is deemed to have inadequate substance in light of the criteria laid down by the proposed Directive; and

-        does not extend to shell companies established outside the EU…

The road to hell is indeed paved with good intentions!

We are given to understand that the Commission is working on a new instrument to deal with situations involving shells in third countries. In the meantime, however, the proposed Directive will paradoxically make shells in third countries more appealing than their EU-resident counterparts, in that they will not be subject to the presumption of misuse, the automatic exchange of information or the risk of penalties.

If it wishes to extend the scope of the proposed Directive to encompass shells resident in third countries, the Commission will first have to answer the tricky question of whether the primacy of EU law means that a Directive can override the provisions of a tax treaty signed between a Member State and a third country[5]. If the answer turns out to be “no”, then any extension of the Directive’s scope would effectively amount to no more than a declaration of intent, with limited effect.

The proposal stipulates that the Member States’ transposition of the Directive must include a penalty for infringement of at least 2.5% of the shell’s turnover[6].

Given the limited turnover of most holdings, it is doubtful how effective this penalty will prove to be. Yet, extending its basis to encompass all proceeds paid to the shell would likely result in penalties that would be deemed manifestly disproportionate to the gravity of the infringement and the extent of the benefit obtained[7]. Doing so could therefore be contrary to Article 8 of the French Declaration of the Rights of Man and of the Citizen, as well as Article 6(1) of the Convention for the Protection of Human Rights and Fundamental Freedoms (ECHR).

For a more comprehensive in-depth analysis of the proposed Directive, you can watch the replay of a webinar organised on 17 February 2022 by Gide Loyrette Nouel and our European partner firms with Savino Ruà from the DG TAXUD (the European Commission’s project leader on the proposal): https://www.youtube.com/watch?v=dGOOxTNo-IM.