ATAD III – What is it and how will it work?

On 22 December 2021, the European Commission published an anti tax-avoidance directive intended to neutralise the misuse of shell entities for tax purposes. Known as ATAD III, the draft Directive is aimed at EU-resident entities, including SMEs, partnerships, trusts and other legal arrangements which claim benefits under double tax treaties and other EU Directives, but which lack a minimum level of economic substance.

The proposal is intended to be transposed into domestic law by EU Member States by 30 June 2023, and to come into effect from 1 January 2024. However, some of the tests are based on the income and activities of the entity within the preceding two years, so a company’s position in the period from 1 January 2022 could be examined.

Whilst economic substance has been a fairly hot topic in recent years, the ATAD III proposals attempt to introduce a more prescriptive, rule-based approach to assessing an entity’s substance, by setting out a series of Gateway tests intended to identify high risk or ‘shell’ entities. The tests are intended to establish whether an entity has a genuine economic link with its country of residence, laying out a minimum level of activity to determine if there is a misuse of an entity for tax avoidance purposes.

The Gateway tests

If the company meets any of the following tests, then it must report specified information in relation to economic substance in its tax return.

Revenue – Was more than 75% of the company’s revenue for the past two years derived from activities not qualifying as business activities (ie passive income)?
Cross-border – Was more than 60% of the company’s revenue generated from cross-border transactions?
Management and administration – Is the company managed in-house, or is this outsourced to an agency?

Are there any exemptions from the rules?

There are some overall exemptions to these for companies:

Listed on a regulated stock exchange
Regulated financial undertakings
Holding companies with no / limited cross-border elements (e.g. managing local operational businesses, if beneficial owners are tax resident in same state; or shareholder/ultimate parent entity is resident in same state)
With at least five full-time employees engaged exclusively in activity generating income.

In addition, the draft Directive includes a further election for exemption from the obligation to report, which would apply where an entity can prove that it was set up for genuine commercial reasons and does not create a tax benefit for itself, its beneficiaries or its wider corporate group.

What’s the Impact?

An entity which meets the conditions or ‘Gateways’ within the proposal (and doesn’t or can’t elect for reporting exemption) must report information on its activities and economic substance within its tax return. As well as the additional administrative burden, an entity may be unable to obtain tax residency certificates, and may ultimately be denied the benefits of double tax treaties and other EU Directives if it fails to provide sufficient evidence that it is not a shell entity.

An entity may also be subject to further financial penalties. Although penalties for non-compliance would need to be set by each EU Member State in its local implementation legislation, the recommended minimum penalty set out in the draft Directive is at least 5% of the entity’s turnover.

The information collected by the tax authorities would be shared with other EU member states under the automatic exchange of information processes, which may also result in more frequent tax audits from local and foreign jurisdictions.

Where are the key risk factors?

If enacted, the Directive would apply to the majority of entities considered to be tax resident in an EU Member State. Key risk factors include:

Companies with foreign investments
Private Equity funds with tiered ownership structures
Companies with mobile or passive income (such as interest, dividends, royalties, rental income) generated from cross-border activities or passed on to foreign entities
Entities with outsourced Directors, administrative operations or decision-making on significant functions.

Whilst entities which meet the criteria are required to declare within their returns whether they meet the tests, the relevant tax authority will ultimately have the final say as to whether the tests are met. If an entity is considered a shell company by the tax authority, the burden of proof to rebut lies with the entity, to prove it either has the minimum level of substance required, or alternatively is not misused for tax purposes.

What steps should businesses be taking?

Whilst non-EU entities (eg UK) are not within the scope of the draft Directive, UK groups with entities within the EU would fall within its scope - and the European Commission has already announced that ATAD III will be followed up with a draft directive which is aimed at non-EU shell companies.

We would strongly recommend that any groups with EU entities that may be at risk consider these rules sooner rather than later – for example, financial services groups and private equity structures may have EU holding companies that fall within the rules.

It will be important for companies to consider whether the gateway exemptions may apply now (given the two-year look-back) rule or if entities within a current group structure will be within scope, and how this could affect the group tax position overall. Where a group has holding companies that are no longer in use, it may be appropriate to remove any which might fall foul of the rules – otherwise, reporting obligations may arise even if there is no tax impact from loss of access to treaties/directives.

We can help examine at-risk entities within the group structure and assist in mitigating any adverse tax impact arising under the proposals.

For help and advice on structuring issues please contact Simon Bird or Lindsey Lopiano.