On 17 January 2023 the European Parliament approved the European Commission’s proposal for a Council Directive to target the misuse of entities for tax purposes by introducing stricter substance requirements. The Directive targets EU tax resident entities that are engaged in cross-border economic activities but have little or no economic substance, known as “shell entities”.
Affected entities, regardless of legal form, that do not have sufficient substance, in the form of income, staff and premises, as per the relevant Directive indicators, shall be presumed not to have minimum economic substance for tax purposes and will in principle qualify as shell entities. In such a case, and if the presumption can not be rebutted or if an exemption can not be granted, those identities could face a number of tax consequences.
Identification of companies that do not meet minimum substance indicators
The Directive provides for three criteria, referred to as “gateways” for identifying companies with insufficient substance. An entity meeting all three criteria will be “at risk” of being considered as a shell entity. Entities which meet only some or none of the criteria will be considered as falling outside the scope of the Directive. The gateways are the following:
1. More than 65% of the revenues accruing to the entity in the preceding two tax years consist of passive/investment income.
2. The entity is engaged in cross-border activity of the following type:
a. More than 55% of the book value of the entity’s certain assets was located outside the Member State of the entity in the preceding two tax years.
b. More than 55% of the entity’s relevant income is earned or paid out via cross-border transactions.
3. In the preceding two tax years, the entity outsourced the administration of day-to-day operations and the decision-making on significant functions to a third party.
Indicators of minimum substance for tax purposes
Entities at-risk shall need to report whether they cumulatively meet a series of substance indicators. Entities, which do not meet all of these indicators will be presumed not to have minimum economic substance and will, in principle, qualify as shell entities. The substance indicators are presented below:
1. the entity has own premises, or premises for its exclusive use or premises shared with entities of the same group in the Member State;
2. the entity has at least one own and active bank account or e-money account in the EU in which its relevant income is received;
3. one or more directors of the entity are qualified and authorised to take decisions on behalf of the entity in relation to the activities that generate relevant income or concerning the entity’s assets;
4. the majority of the full-time equivalent employees of the entity have their habitual residence in the Member State of the entity, or are at no greater distance from that Member State insofar as such distance is compatible with the proper performance of their duties.
Rebuttal of the presumption
Entities qualifying as shell entities will have the opportunity to either rebut this presumption by providing additional supporting evidence of the business activities that they perform to generate their revenues, or to request for an exemption, on the grounds that their existence does not create a tax benefit.
Member States should take measures to enable entities that are presumed not to have minimum substance to rebut this presumption, without undue delay and excessive administrative costs, by providing additional supporting evidence, as follows:
1. a document allowing to ascertain the business rationale behind the establishment of the entity in the Member State where the activity is performed;
2. information on the profiles of full-time, part-time and freelance employees without compromising data protection and privacy provisions.
The relevant Member State should examine a request for rebutting the presumption within a period of nine months. In the absence of an answer within the nine-month period, the request will be considered as accepted.
Where it will be considered that an entity has satisfactorily rebutted the presumption of being a shell entity, the relevant Member State should certify that the entity has minimum substance for tax purposes. This certification should remain valid for up to 5 years.
Tax consequences for shell entities
Where an entity does not have minimum substance in the Member State where it is resident for tax purposes, that Member State should deny any request by the entity for a certificate of tax residence for use outside the jurisdiction of that Member State. Such denial should be accompanied by an official statement duly justifying such decision and prescribing that the entity is not entitled to the benefits of agreements and conventions that provide for the elimination of double taxation of income, and, where applicable, capital, or of international agreements with a similar purpose or effect.
This means that such an entity will face a number of potential tax consequences, including denial of access to the benefits of Double Tax Treaties or EU Directives, and possibly enhanced exchange of information and tax audits. Furthermore, there will be penalties for failure in complying with the provisions of the proposed Directive.
Entry into force
If approved by the European Council the Directive will need to be transposed by Member States in to their national legislation by 30 June 2023 and come into effect on 1 January 2024. The Directive provides for a look-back period of two years for verification of the gateways, so assuming it will come in to force at the beginning of 2024, the facts and figures of 2022 and 2023 will be considered. This means that entities currently operating legitimately could be caught within the scope of the Directive if it is implemented in 2024.
How we can help
We strongly encourage all Cyprus entities that might be affected, to consider their current structure, and assess whether there is a potential reporting obligation under the proposed Directive.
We can assist on the following areas related to substance:
