ATAD 3 Directive: EU Substance Requirements for Holding Companies

ATAD 3 Directive: EU Substance Requirements for Holding Companies

At TaxCorp, we observe that the proposed European directive ATAD 3, also known as 'Unshell', is causing significant concern. This regulatory framework aims to prevent the misuse of companies lacking genuine economic substance for tax advantages. For many of our family office and Latin American business group clients with substantial investments in Europe, this necessitates a thorough review of their current and future structures.

What is the ATAD 3 Directive and why is it relevant?

The Anti-Tax Avoidance Directive 3 (ATAD 3) is a European Commission initiative designed to combat the misuse of shell entities that lack true economic substance but are used to divert profits and reduce tax burdens. It's relevant because it imposes strict criteria that, if not met, can lead to the loss of significant tax benefits and double taxation. Its ultimate goal is to ensure that profits are only allocated where genuine economic activity occurs.

How does ATAD 3 identify a high-risk or 'shell' entity?

ATAD 3 uses a system of 'gateways' or cumulative criteria to identify high-risk entities. An entity will be considered high-risk and potentially a 'shell' if it meets the following three conditions:

1. Predominantly passive income: The entity derives more than 75% of its income from passive sources, such as interest, dividends, royalties, or the sale of real estate. This is a critical point for holdings and investment vehicles. This percentage is calculated based on total income over the two preceding tax years.
2. Predominantly cross-border activity: More than 60% of the book value of its assets are real estate located in another country, or assets that, in the two preceding tax years, generated passive income from another country. Alternatively, more than 60% of its income is generated through cross-border transactions.
3. Outsourced management: The entity has outsourced the administration and day-to-day management of its operations. This is common for holdings with limited staff or external directors.

If an entity meets these three 'gateways', it will be presumed to be a shell entity and must report additional information on its substance in its tax return. There are some exceptions, for instance, for regulated entities, publicly traded companies, or certain types of investment funds, but these are limited.

What economic substance indicators must be demonstrated to avoid being considered a 'shell'?

Once an entity qualifies as high-risk, it must demonstrate real economic substance by presenting evidence of the following indicators in its tax return:

• Own or exclusive-use premises: The entity must have its own office space or an exclusive right to use office space in the Member State where it is established.
• Active EU bank account: It must maintain at least one active bank account in the European Union, used for its economic activity. This ensures a tangible link to the local financial system.
• Qualified resident directors or staff: It must have at least one director or a sufficient number of full-time employees who meet the following requirements:
• The director or a majority of directors are tax residents in the same Member State as the entity, or a majority of the entity's employees are tax residents in the same Member State and are qualified to make decisions regarding the entity's income-generating activities.
• Such individuals are not employees or directors of other unaffiliated entities.
• They have the authority to make decisions regarding the entity's income-generating activities.

The directive specifies the qualifications and responsibilities expected of directors or employees to ensure that management is genuine and not merely a facade.

What are the tax consequences of being classified as a 'shell' under ATAD 3?

The consequences are severe and eliminate the tax advantages typically sought by holding structures. An entity designated as a 'shell' will face:

• Denial of treaty benefits: It will not be able to access the benefits of double taxation treaties signed by its Member State of residence. This means, for example, that withholding taxes on income (such as dividends, interest, or royalties) will not be reduced, potentially leading to double taxation.
• Denial of EU directive benefits: It will be denied access to the advantages of key EU directives, such as the Parent-Subsidiary Directive (2011/96/EU) and the Interest and Royalties Directive (2003/49/EC). These directives are fundamental for the exemption of withholding taxes between EU companies and the elimination of double taxation at the holding entity level.
• Automatic information exchange: Information about the 'shell' entity and its lack of substance will be automatically shared with tax authorities in other EU Member States and, potentially, with third countries with which the EU has information exchange agreements. This can trigger audits and reviews in the jurisdictions of the ultimate beneficial owners.
• Reclassification of income: In some cases, the income of the 'shell' could be taxed directly in the jurisdiction of the ultimate shareholder, as if the entity did not exist from a tax perspective. This is a concept similar to tax transparency.

For instance, if a Luxembourg holding company, used by a LatAm group, does not meet the substance requirements, dividends it receives from an operating subsidiary in Spain could be subject to the full Spanish withholding tax (e.g., 19% or 21%) instead of being exempt under the Parent-Subsidiary Directive. Furthermore, dividends distributed by the Luxembourg holding to its ultimate shareholders outside the EU could be taxed in Luxembourg without treaty benefits, exacerbating the overall tax burden.

What should Latin American investors with European structures do?

It is crucial for Latin American family offices and business groups with a presence in the EU to take proactive measures. At TaxCorp, we recommend the following steps:

1. Exhaustive diagnosis: Conduct a detailed analysis of all existing European entities to identify which meet the ATAD 3 risk criteria. This involves reviewing the nature of income, the volume of cross-border operations, and the management model.
2. Substance evaluation: For entities at risk, evaluate the current level of economic substance against ATAD 3 indicators. This should go beyond a simple 'check-the-box' and consider operational reality and decision-making capacity.
3. Strategic planning: Develop an action plan for each entity with deficiencies. Options may include:

• Reinforcing substance: Increasing local staff, renting own offices, ensuring directors have the authority and time for critical decisions. This implies an increase in operating costs.
• Function consolidation: Restructuring to consolidate multiple holdings or functions into a single operating entity with robust substance in one Member State, achieving efficiencies and complying with the directive.
• Relocation: Evaluating the possibility of moving the holding function to non-EU jurisdictions or creating new structures outside the EU that better align with the group's strategy.
• Liquidation: Considering the liquidation of vehicles that prove inefficient or unsustainable under the new rules, freeing up capital and simplifying the structure.

Each of these options must be carefully analyzed, considering transfer pricing rules, Controlled Foreign Company (CFC) rules in the resident countries of the ultimate shareholders, and other tax and legal implications. ATAD 3 is not an isolated event but part of a global trend towards requiring economic substance, a principle already central to the OECD's BEPS initiatives.

At TaxCorp, we are prepared to assist our clients in this analysis and in implementing the most suitable solutions for their international structures.