Minimum substance test under EU shell company directive

In December 2021, the European Commission (EC) published its draft Council Directive, amending Directive 2011/16/EU (the Directive) and setting out the rules to prevent the misuse of shell entities for tax purposes.

The EC has observed that certain individuals and some businesses direct their income to shell entities with little substance registered in jurisdictions that have no or very low taxes. This is done to shield assets and real estate from taxes, either in their country of residence or in the country where the property is located.

The draft Directive provides a set of indicators that help determining if an entity is a shell and the applicable sanctions.

The indicators focus on income-generating activities, cross-border involvement outsourced activities, so that if more than 75 per cent of an entity’s total revenue does not come from trading activity or if more than 75 per cent of its assets are real estate property or other private property of particularly high value the entity is considered a shell. The same applies to entities receiving most of their income through transactions linked to another jurisdiction.

If, in addition to this, the company is also outsourcing most of its activities, it will be required to annually report information to the tax authorities on its premises, its bank accounts and the tax residency of its directors and employees.

Any entity failing at least one of the substance tests will be deemed to be a shell, and will be denied tax relief under any double tax treaty or EU directive. Moreover, any payments it makes to third countries on behalf of another party will be subject to withholding tax at the level of the client party.

To help identify shell companies, Member States’ authorities will automatically exchange information on all entities in scope of the Directive, whether shell entities or not.

Member States will also have the power to request another Member State to conduct a tax audit of any entity that reports there and to communicate the outcome to the requesting Member State.