EU shell company directive aims to crack down on tax abuse

By Doug Connolly, MNE Tax

A proposed directive released by the European Commission on December 22 will step up efforts to tackle the use of shell companies to avoid taxes by denying tax benefits for entities deemed to be shell companies and adding new reporting requirements in certain circumstances.

“This proposal will tighten the screws on shell companies, establishing transparency standards so that the misuse of such entities for tax purposes can more easily be detected,” European Commissioner for Economy Paolo Gentiloni said. “Our proposal establishes objective indicators to help national tax authorities detect firms that exist merely on paper.”

The proposal sets out three levels of indicators to help tax authorities identify shell companies. If the entity is flagged under one of the indicators, it will be deemed a shell company and denied certain tax benefits. If it is flagged under all three, the entity will be subject to additional reporting requirements.

The first level of indicators looks at the company’s income and assets to evaluate if the bulk of the entity’s income is passive. The indicator is triggered if more than 75% of an entity’s revenue in the previous two years does not derive from the entity’s business activity or if more than 75% of its assets are real property or other passive income–generating property.

The second level of indicators reviews whether most of the entity’s transactions are cross-border. It is triggered if the company gets most (60%) of its relevant income from transactions linked to another jurisdiction or passes this relevant income on to companies abroad.

The third level of indicators considers the company’s management and administration and is triggered if such services, in the preceding two years, were generally outsourced rather than performed in-house.

Entities deemed to be shell companies due to being flagged under one of the indicators will lose access to certain tax relief and tax treaty benefits intended to support real economic activity. Additionally, payments passing through a deemed shell company to third countries will not be treated as flowing through the shell entity and instead will be subject to withholding tax at the level of the entity that paid the shell company.

Entities that are flagged under all three indicators will also have to report information in their tax returns relating to economic substance. This includes information on the company’s premises and bank accounts, as well as the tax residencies of directors and employees. These declarations must be accompanied by supporting evidence.

Entities that are deemed to be shell companies may contest the decision under the directive. To do so, such entities must present additional evidence establishing the commercial (non-tax) reasons for their establishment, as well as that their decision-making is taking place in the entity’s state of residence.

The directive is proposed to come into force on January 1, 2024, following adoption by EU member states.