On December 22, 2021, the European Commission (EC) released a proposal for a council directive (CD) amending the Council Directive 2011/16/EU on Administrative Cooperation (DAC) and laying down rules to prevent the misuse of shell entities for tax purposes. The EC’s proposal targets shell companies and has two main objectives, namely:
(i) Transparency: All entities engaged in commercial activities that are residents of a member state, and eligible to obtain a tax residency certificate in a member state, will have to disclose “objective indicators” related to income, staff and premises. The three indicators will be used as the first indicia of economic substance in a filtering system described as a “gateway” system. An entity that crosses the three gateways will be required to disclose in its tax return additional information related to its premises, bank accounts, and directors’ and employees’ tax residency. These are called “substance indicators.” These tax return disclosures will require supporting documentation. Failing a “substance indicator” will result in a presumption that the said entity is in fact a shell entity. That presumption can be rebutted by presenting additional evidence, such as detailed information about the commercial reasons for residency in the member state, profiles of employees and evidence of decision-making in the member state of residency. An entity that fails rebuttal will be deemed as a shell entity.
(ii) Denial of Tax Benefits: Entities of a member state that fail to successfully rebut the presumption of being shell entities, and are deemed shell entities, will be denied tax benefits under the treaty network of their member state and will not be qualified for treatment applicable under the parent-subsidiary and interest and royalties directives. In addition, payments originating from a deemed shell entity will be subject to withholding taxes at the level of the entity that paid the shell entity. To facilitate the implementation of the CD, member states of a deemed shell company will either deny the shell company’s tax residency certificate or disclose on the certificate the deemed shell status of the company.
Once adopted by member states, the EC’s proposal is expected to become a CD effective on January 1, 2024. Whether an entity is deemed a shell entity, it will not be a limiting factor for the exchange of information concerning that entity between European tax administrations under the DAC. Payments from a deemed shell company to an entity outside of the EU or from an entity outside of the EU to a deemed shell company will not be denied treaty benefits, but the entity outside the EU may be asked to “look-through” the shell company for determining the payor or payee of a payment. The goal of the CD is to discourage multinational enterprises (MNEs) to use the shell entities set-up as a resident in a member state for the sole purpose of avoiding taxes; the EC recognizes that some low-economic activity shell companies may have a legitimate economic and commercial purpose, but the burden to demonstrate such economic or commercial purpose is now placed squarely on the shoulders of each resident entity.
Takeaway for U.S. MNEs
The CD will impact U.S. MNEs operating in the EU through low-economic activity entities engaged in intercompany transactions involving payments to or from entities in other member states. These MNEs should consider self-assessing the outcome of the three gateways (income, staff and premises) applied to their EU entities. This initiative by the EU adds a layer of compliance to the OECD’s Pillar One and Pillar Two expected in 2023 and 2024, respectively, and to the layers of compliance caused by country-by-country reporting and other OECD/G20 base erosion and profit shifting (BEPS) deliverables. It also signals the increasing active role played by the EC in fighting tax avoidance, base erosion and perceived unfair tax competition. This initiative, however, is somewhat remarkable in that it addresses the economic substance of resident entities. The 2017 revisions to Chapter I of the OECD Transfer Pricing Guidelines already substantially increased economic substance requirements. This proposed CD, therefore, may signal the EC’s significant skepticism on the effectiveness of the OECD to curb perceived abuses of the international tax systems by MNEs.
Kroll and its transfer pricing professionals will continue to monitor developments at the OECD and the EC. Please contact your Kroll transfer pricing advisor for further information about this proposed CD and appropriate ways to prepare for its expected 2024 implementation.