Shell companies. How to avoid being a shell company?

In December 2021, the European Commission published a draft Council Directive which amends Directive 2011/16/EU. The Directive provides rules to prevent the use of shell companies for tax optimization purposes.

The actions of the European Commission were an adequate response to the abuse of loopholes in the law by some enterprises, namely, some companies divert their income to shell organizations that are registered in jurisdictions with very low or no taxation at all. This applies not only to companies, but also to individuals. Individuals also often use shell companies to protect assets and real estate from taxes in their country of residence, or from the country in which the real estate is located. As a rule, such organizations do not have a significant presence in the country of registration.

The directive proposes 2 categories of measures: a set of criteria for determining a shell company and a set of sanctions that can be applied if the company is found to be a shell company.

For verification, the so-called “The Minimum Substance Test” will be introduced, which will be divided into 7 stages.

1. Companies are required to report if they meet the following criteria:

• if more than 75% of the company’s income comes from activities not related to the sale of services/goods or more than 75% of the company’s assets is real estate or other property of particularly high value.

• cross-border participation, i.e. how much the company operates in the international market in reality. A company is deemed to have failed the test if the company derives the majority of its income through operations related to another jurisdiction, or transfers this income to other companies located abroad.

• company administration, day-to-day operations and important decision-making are outsourced.

If a company meets the above criteria, then such a company is considered high-risk and will be required to pass the second stage.

2. Reporting

The annual tax return must disclose information that confirms that the company has a minimum presence in the country (substance), which includes the presence of premises for the exclusive use of the company, an active bank account in the European Union, and at least one qualified director who is a tax resident in the jurisdiction or located reasonably close to the facility.

An alternative to a local director may be a sufficient number of full-time resident employees engaged in the main income-generating activities of the enterprise.

3. Presumption of Sufficient Substance and Tax Abuses

At this step, the tax office decides whether the company is fictitious or not.

If the required criteria are met (premises, an active bank account in the EU and a qualified director(s) or tax resident staff) and supported by relevant documents, then there is a presumption that the company is not fictitious, however, if the documents provided are not enough, the tax service has right to recognize the company as a shell.

Everything will depend on the credibility of the documents provided.

4. Appeal

If a company is found to be shell, then such a company has the right to appeal. The burden of proof is on the company and the company needs to establish specific facts and reasons for its existence. In case of a successful appeal, the enterprise receives an extension of status for 5 years (6, including the year of consideration) and will have this status, subject to legal and factual circumstances that were previously verified by the tax service.

5. Exemption due to lack of tax motives

Some companies may not pass the first stage test and may not meet the substance criteria in stage 2, but nevertheless, such companies could be created for real commercial activities and do not create a tax benefit, do not have the purpose of tax avoidance by the company or group companies to which the company belongs.

In such a case, the entity may request a tax exemption certificate due to lack of tax incentives. This certificate will be valid for 5 years (6 including the year of review) and will be valid subject to the legal and factual circumstances previously reviewed by the tax office (as in step 4).

6. Consequences

If, as a result of the above checks, the company receives the status of Shell company, then the following consequences await it:

• the company will not be able to obtain a tax resident certificate, or such a certificate will contain a note that this company cannot rely on the application of double tax treaties.

• the company will have the right to continue operating in accordance with the national legislation of the country of registration of the company. However, various tax advantages will not apply.

7. Information exchange

The States covered by the Directive will exchange information quickly and extensively between Member States with links to shell companies in the European Union. For this purpose, an information system has already been created.

8. Fines

Penalties will be imposed at the discretion of the Member States, but with a note that the penalties must be effective, proportionate and dissuasive.

The directive proposes to provide for a minimum fine of 5% of the company’s turnover.

Timeline

Once the Directive is adopted, Member States will have until 30 June 2023 to amend their national legislation. It is expected that from January 1, 2024, the Directive will become fully operational. Well, this is quite an ambitious timeline, given the scale of the reforms.