The EU’s ATAD 3: How to prepare, and not overreact

6 April 2022
When the European Commission published a draft Directive at the end of 2021 aimed at preventing the use of shell companies for tax purposes in the EU, it was widely recognised as a logical next step in an ongoing clampdown on tax avoidance and aggressive tax planning.

Known as the Anti-Tax Avoidance Directive III (ATAD 3), the proposal follows previous iterations of EU legislation. ATAD 3 proposes to introduce a minimum substance test targeting shell companies that don’t perform “actual economic activity.”

The proposal has met with scepticism in certain quarters, with some commentators noting there’s a swathe of EU substance and anti-tax-avoidance regulation already in place. They’ve further suggested that tax authorities have existing options available to them and that adding requirements will only increase the complexity and cost of doing business in Europe.

Holding and financing companies — including special purpose vehicles (SPVs) — are particularly concerned about the effects the proposal might have on them.

In this article we cover some of the key elements of the draft Directive and how certain entities could be affected. We also outline some actions companies should take to prepare.

Minimum substance rules: The three gateways

The draft Directive has outlined the following three “gateways,” which determine whether an entity is at risk of being considered a shell company.

  • More than 75 percent of the entity’s revenue in the two years prior to the Directive being implemented is “passive income.” This includes: interests, royalties, dividends and capital gains on shares; income from immovable properties, insurance and banking income; and leasing income and income from movable properties with a book value of more than one million euros. (Income that falls under these categories is considered “relevant income.”)
  • The entity is mainly engaged in cross-border activities, with more than 60 percent of relevant income generated from these activities or passed on to foreign entities.
  • The entity has outsourced the administration of day-to-day operations and decision-making on significant functions.

Under the proposal, if an entity crosses all three gateways, it must declare economic substance-related information on its tax returns. Specifically, the entity must declare if it has: an active EU bank account; its own premises; and at least one local independent director or full-time employee.

Important considerations

The above summary is of course a high-level one. The proposed Directive is on some points ambiguous. For example, the final gateway (relating to outsourcing) may be subject to wide interpretation. It appears that many SPVs could fall within its scope, though this isn’t certain.

Also, while there is an exemption for alternative investment funds, the proposal is unclear as to whether a holding company owned by such a fund would be exempt.

It’s also important to note that some entities — including listed companies and certain regulated financial companies — are excluded from reporting obligations under the proposal because they are already subject to a high level of scrutiny under existing regulations.

Finally, companies should keep in mind that the proposed Directive may change before it’s implemented.

Why ATAD 3 matters now

ATAD 3 is a proposal, but recent EU legislation suggests there will be pressure on the European Commission to ensure the proposal doesn’t change much. If the Commission deems that clarifications or changes are required, it may pass them later using additional guidance or related regulations.

While ATAD 3 is not set in stone, companies should keep in mind that the proposal’s consequences could be significant. For example, if an entity is ruled a shell company under the proposal, the entity will be unable to access any tax relief or double tax arrangements of its EU member state.

Another major consideration is ATAD 3’s two year “look-back” period. If approved in its current form, ATAD 3 would require transposition into domestic law by 30 June 2023, with enforcement from 1 January 2024. Given the look-back period, an entity’s status from January 2022 onwards would be relevant when making determinations, starting January 2024.

Next steps for companies

Given the potential consequences of ATAD 3 — including those of its look-back period — we recommend that companies now examine whether they may fall within the proposal’s scope. Specifically, a company should:

  • Understand the three gateways as far as possible given the uncertainties related to the outsourcing gateway and more.
  • Understand whether an entity crosses the proposal’s gateways given the entity’s unique situation.
  • If an entity crosses the gateways, consider what steps it could take to change its status in order to either 1.) not cross a gateway or 2.) meet substance-related requirements (for example, by opening a local bank account) under the proposal’s substance criteria.
  • If changing an entity’s status isn’t feasible, determine if an exemption request may be filed under the proposal.

It should be emphasised that the above steps are preliminary. We recommend companies refrain from taking significant steps now, such as restructuring or incorporating in a non-EU jurisdiction. These kinds of actions will be costly and may prove unnecessary if the Directive language changes — and in some cases may be unnecessary even if the language remains the same.

Put simply, companies should understand the current proposed Directive and put themselves in a good position to comply should it go into effect, while also remaining flexible in the event the proposal changes. Companies should also closely follow related developments, which are evolving quickly.