CIT - Draft Directive on 22 December 2021, known as the anti-tax avoidance Directive III ("ATAD III")

Introduction of a "minimum substance test" for EU companies.

Opening remarks

In December 2021, the European Commission published the Council Directive laying down rules to prevent the misuse of shell entities for tax purposes and amending Directive 2011/16/EU.

The entry into force of the new law will introduce the obligation to thoroughly verify the possibility of applying (i) reduced tax rates from double taxation treaties, (ii) withholding tax reliefs under the Parent-Subsidiary Directive and the (iii) Interest and Royalties Directive. Thus, in practice, the payment of receivables, e.g. between entities from one capital group, will require an economic substance test to apply the withholding tax exemption in the paying country.

The purpose of the Directive is to eliminate the functioning of the so-called shell entities that were established solely or mainly to benefit from tax preferences under double taxation treaties or tax exemptions under European directives.

As can be deduced from the Directive, legal entities with no minimal substance and economic activity continue to pose a risk of being used for improper tax purposes, such as tax evasion and avoidance. Hence there is a need for further action to tackle situations where taxpayers evade their tax obligations or act against the actual purpose of tax law by misusing entities that do not perform any actual economic activity. The outcome of such situations is to lower the taxpayer’s overall tax liability and leads to a shift of the tax burden at the expense of honest taxpayers and distorts business decisions in the internal market.

The Directive is broadly inclusive and aims to capture all entities that can be considered resident in a Member State for tax purposes, regardless of their legal form. It should be noted that it also covers legal arrangements, such as partnerships, that are deemed residents for tax purposes in a Member State.

In conclusion, the Directive targets a specific scheme used for tax avoidance or tax evasion purposes. The scheme consists in creating enterprises in EU which only seemingly are involved in economic activity, but in fact do not conduct it. They exist only to bring specific tax benefits to the beneficial owner or the entire group to which they belong. According to the Directive, such entities should have the status of a shell entity.

Economic substance test

The Directive listed conditions that must be met in order to consider a given entity as a shell entity.

The most important of them are as follows:

a) more than 75% of the in the preceding two tax years is relevant income;

b) more than 60% of the book value of the certain assets was located outside the Member State of the undertaking in the preceding two tax years;

c) at least 60% of the undertaking’s relevant income is earned or paid out via cross-border transactions;

d) in the preceding two tax years, the undertaking outsourced the administration of day-to-day operations and the decision-making on significant functions

Fulfilment of the above-mentioned conditions means that the entity will be required to submit an appropriate report. Afterwards, this entity will be required to declare in their annual tax return, for each tax year, whether the following indicators of minimum economic substance are met i.e.:

a) the undertaking has own premises in the Member State, or premises for its exclusive use;

b) the undertaking has at least one own and active bank account in EU;

Moreover, appropriate documentation should be attached to the tax return, for example:

a) address and type of premises;

b) the amount of gross revenues and their type;

c) the amount of operating expenses and their nature.

Tax implications

If the entity subjects to the reporting obligation do not prove that it has a minimum asset and personal substrate, it will be assumed that it shall be treated as a shell entity. If this assumption is not rebutted the entity will not be entitled to tax benefits resulting from tax agreements concluded in the country of its seat and exemptions under EU Directives.

Therefore, it cannot be ruled out that the shell entity will not be able to apply the reduced tax rates resulting from the double taxation treaties and tax exemptions guaranteed by the EU directives. The inability to apply tax preferences may therefore concern in particular the dividends, royalties, interest and intangible services.

It is also worth noting that the state in which the shell entity is registered may not obtain a tax residence certificate.

New duties

The new regulations may apply from the beginning of 2024.

Upon their entry into force, the taxpayers, in particular those belonging to tax capital groups should verify the cash flows in the light of making payments to entities without economic substance within the meaning of the Directive.

It is noteworthy that in many countries, including Poland, CIT Acts already requires counterparty verification as part of the due diligence process carried out in the case of e.g. withholding tax exemption. In practice the subject of due diligence is to verify the compliance of documents received from contractors in the light of conducting actual economic activity, the actual place of management as well as beneficial owner status.

After the Directive enters into force, this process will be of particular importance, bearing in mind that the new law introduces the obligation to exchange information on shell companies between Member States.