ATAD 3: Unshell Directive

16 December 2022

The ambitious nature of ATAD 3 (the EU directive designed to prevent the misuse of shell entities for improper tax purposes) to harmonise substance requirements across EU Member States and deny treaty/directive benefits has made its passage to implementation uncertain.

In its initial form, published at the end of December 2021, the directive prompted concerns around the application to the asset management industry as it neglected the role genuine holding vehicles play in a fund structure, although some comfort could be taken that key exemptions would take some entities out of the regime.

There remains significant uncertainty regarding the final form of the directive (assuming it gets that far). Since the directive was published the European Parliament has put forward a series of non-binding amendments (the final version of which was endorsed by the Parliament on 23 November 2022) that suggest there is greater awareness of the role that some vehicles play in investment structures, however there are also camps that want the Commission to introduce even stricter requirements potentially removing exemptions entirely. Luxembourg’s Finance Minister conspicuously commented that the directive “overshoots the mark” therefore amendments have long been expected given the directive requires unanimity for adoption.

At the most recent Ecofin meeting (6 December 2022) the European Council issued a tax report providing an overview of progress made on the file under the Czech Presidency. It could only be reported that negotiations had “advanced”, and that “important technical work” was needed before approval by Council members. Reading between the lines this highlights the challenge the directive faces.

There are likely to be more twists and turns before ATAD 3 is adopted. As the Czech Presidency comes to an end, this note provides an overview of the directive and highlights where the rules might change based on proposals put forward by the European Parliament. As the file moves to the Swedish Presidency in 2023, despite support for the objectives of the proposal, the file is not seen as a priority, therefore tangible movement is not expected until the second half of 2023. In the meantime, keeping abreast of the changes will be important to ensure you are ready to react.

Outline of ATAD 3

The directive is designed to tackle the use of EU based shell entities with minimal substance that have been used for improper tax purposes and does so by introducing a newly devised minimum substance test. The proposals come at a time when the concept of substance has been of increasing interest to tax authorities when determining eligibility for treaty benefits, often used as a proxy for residence and beneficial ownership despite not being an explicit term used in double tax treaties. By way of recap the regime is designed to identify undertakings that have minimal substance and economic activity in an EU Member State and introduces a series of steps designed to prevent their use. This is achieved through filter mechanisms to identify entities that display certain risk indicators which are summarised below.

How might the rules change?

The final form of the directive is subject to negotiations between the 27 Member States. The amendments proposed by the European Parliament have some standing and are likely to infuence those negotiations, however they are not seen as binding. The key changes affecting asset managers are summarised below.

The carve-outs

Given the breadth of the directive, the carve-outs set out in Article 6(2) play a crucial role in determining whether an undertaking is within the scope of the rules. In an ideal world, this first filter should take out genuine holding vehicles.

  • If it remains, the regulated financial undertakings carve-out will do a lot of the heavy-lifting for the industry (taking out AIFMs, UCITS and AIFs amongst others), however, under the current drafting the carve-out only applies on an entity- by-entity basis. This means holding vehicles or entities that may not themselves be regulated in a fund structure (even though they may be under common management with a regulated entity) are potentially exposed to the effects of the Directive.

    We understand the Commission is reviewing its position on this aspect and may adopt the approach settled on by the OECD Pillar Two proposals which employs a broader definition of investment funds and their holding structures. The European Parliament amendments first published in May 2022 offered some potential respite with an amendment proposed that would mean entities owned by regulated financial undertakings with a purpose of holding assets or investments would also be exempt (Amendment 15). The September 2022 edition of amendments were less encouraging with proposals to remove the regulated financial undertakings exemption entirely (Amendments 105 and 106) or restrict the carve-outs to undertakings not taking advantage of directive tax benefits (Amendment 104). The final amendments endorsed by the Parliament in November 2022 left the exemption unchanged. The spectrum of amendments is indicative of the political camps within the European Parliament. It should be emphasised that the amendments are advisory for the Council rather than binding.

  • The directive makes some attempt to carve-out domestic holding companies, however its operation, as the name suggests, has limitations. Under Article 6(2)(d) only undertakings with holding activities that are resident in the same Member State as the undertaking’s shareholders or ultimate parent entity are excluded. 

    That said, as it currently stands most commentators expect this should allow a double tier of entities resident in the same location to qualify for the domestic holding company exemption where the top company is not itself caught by the directive i.e. it is a regulated financial undertaking or it satisfies the minimum substance requirements. A typical Master Lux Co with sufficient substance along with a Luxembourg subsidiary may therefore satisfy this test.

  • Another carve-out from the directive relates to full time employees. Under Article 6(2)(e) undertakings with at least five full-time equivalent employees or members of staff exclusively carrying out the activities generating the income are not subject to the requirements of the directive. 

    Although the current draft of the directive does not impose any requirements around the location of those employees or what role they play, the reality is there will be few entities below the fund that employ staff. Often staff will be employed by a local service company providing services across a number of different entities and different funds and whilst commercially this makes sense - allowing employees to roll-on and off funds without having to continually change employment contracts - the current directive takes a much more limited view by testing employees on an entity-by-entity basis. 

    The number of staff required (5) under the current directive is arbitrary and bears no relation to the size or industry. It will be interesting to see whether this requirement changes.
The gateway test

If it is not possible to satisfy one of the carve-outs the next filter to work through is the gateway test. The gateway test set out under Article 6(1) aims to identify entities that are at risk of lacking substance and imposes a reporting requirement if all three criteria are met (irrespective of whether the undertaking is ultimately determined to be a shell entity).

The crucial test (under Article 6(1)(c)) is whether the entity has outsourced the “administration of day-to-day operations and the decision-making on significant functions”. As it is currently drafted the test requires both the administration and decision-making to be outsourced, so where decision- making is retained and performed by directors in-house this test might not be the hazard it first appears to be. This anomaly has not been picked up by amendments. If this gateway remains unchanged a disproportionate focus will be placed on the meaning of "decision-making" and significant functions. 

There is however an amendment proposed to clarify that outsourcing should be focused on third parties. This was a point made in multiple responses to the consultation therefore we expect the treatment of outsourcing to evolve in the compromise text. 

The amendments proposed in relation to Article 6 do not offer any clarity on what “outsourcing” means. In one of the earlier rounds of amendments (in relation to a different point about reporting) outsourced activity is defined as “accounting, sales, marketing, logistics, consulting etc”. This would appear to be a very broad range of services, much wider than the use of third-party professional directors or domiciliation and entity management services that might be typically associated with entities having minimal levels of substance.

Indicators of minimum substance

Undertakings that are caught by the gateway test will need to report in their annual tax return whether they meet certain indicators of minimum substance. Meeting all three of the indicators means the undertaking is presumed to have the requisite level of substance. However, if not, the undertaking is considered a “shell” and will face the tax consequences unless it can rebut the presumption or avail itself of one of the final exemptions offered. 

In practice the bank account and qualified people tests should be straightforward to satisfy. However, the lack of clarity around the premises test has caused some uncertainty around its potential reach, for example, would the use of rented office space meet the definition of “own” premises? Furthermore, where the premises are used by a number of group entities there is a risk that the “exclusive use” test is not met by the entity. The amendments do not provide much clarity at this stage. In our view, if the property is rented, by say a Master LuxCo and other group entities use the property under a licence, the licensees i.e., other group entities using the property could be said to have the non-exclusive possession of the property, leaving the Master LuxCo with “exclusive use”. It is worth noting that where a company does own its own premises, other group companies can use the property as the “exclusive use” condition appears to be drafted as an alternative test. Building on this, there is an amendment that seeks to include “premises shared with entities of the same group”. 

Last refuge – the rebuttal of presumption or exemption

Where the minimum substance requirements are not met, there are two further options to consider. The first is the rebuttal of presumption which involves providing evidence around the commercial rationale and operations to prove that the undertaking has control and operations to prove that the undertaking has control over and borne the risks of the business activities. Although not ideal, this may in practice be possible to satisfy due to the number of commercial non-tax reasons why a holding company might be used in a fund structure. 

The second option is a request for an exemption where it can be proved that the undertaking does not reduce the tax can be proved that the undertaking does not reduce the tax might be more difficult to satisfy as it requires comparing the amount of tax due with and without the interposition of the undertaking. While the main objective of the holding company is to ensure a fund structure does not create an additional layer of tax, there are circumstances where it can also create a more favourable withholding tax outcome for investors than if they had invested directly. 

Does a UK asset holding company offer any solace?

The directive targets EU resident undertakings so a non-EU holding company could offer a viable alternative. For certain managers the introduction of the UK Qualified Asset Holding Company regime provides a well-timed alternative, however, the EC has made it clear that it intends to introduce further regulations to target non-EU entities.

Work is currently underway to design these mechanisms, but it will clearly be constrained. The EC will not be able to override bilateral tax treaties so it will be forced to adopt a soft-law approach. The first measure the Commission has put forward is a regulatory framework for tax intermediaries that are involved in the creation of arrangements outside of the EU that facilitate tax evasion or aggressive tax planning in the EU the so-called SAFE (Securing the Activity Framework of Enablers) initiative.

The EU list of non-cooperative jurisdictions for tax purposes is also under a separate review. These could be used as a mechanism to encourage third countries to adopt similar standards to ATAD 3. Although the UK is likely to resist such pressure, standards may eventually converge towards those set by ATAD 3. 

What does this mean in practice?

If an undertaking has been classified as a “shell” entity, a number of tax consequences are laid out in the directive. The most significant is that the undertaking will not be entitled to the tax benefits of the EU Directives, potentially, double tax treaties. This will have implications for shareholder and investee jurisdictions which will be forced to effectively look-through the shell entity. Although the directive is limited in the extent to which it can override bilateral tax treaties, a corollary of this directive may mean some investee jurisdictions attempt to use the new minimum standard as a safe harbour which could bring its own problems. This coupled with the ability for EU Member States to be able to request tax audits on shell entities may create newfound friction in some structures.

Although it will be important to evaluate any structure for potential shell entities, it should be possible to navigate the gateway test and indicators of substance to sidestep the tax consequences in many cases. There are a few key points to keep in mind.

  • As it currently stands, satisfying one of the carve-outs will largely be an objective exercise which turns on whether the undertaking is listed in one of the derogations under Article 6(2) such as a regulated financial undertaking or a holding company based in the same jurisdiction as the shareholders. The best scenario will be for an undertaking to satisfy one of these exemptions to wipe-out as many at-risk entities as possible.
  • If not, the outsourcing condition in the gateway test is likely to prove critical in determining whether an undertaking falls within scope of the directive. As such, making sure documentation like board minutes and resolutions are available to support the fact that decision-making sits with directors will be important.
  • If there is no route through the directive, it might be worth considering a non-EU entity particularly where the investment strategy focuses on non-EU investments. The UK Qualifying Asset Holding Company regime may offer an alternative if the eligibility criteria can be satisfied, however this approach is not without risk until is clear what approach the EC intends to take to prevent it the use of non-EU shell entities. 

Are you caught?

Under current drafting, the scope of ATAD 3 is broad. Unlike other measures, there is not de minimis test so this may ultimately apply to all fund structures irrespective of size. Furthermore, the directive applies to all undertakings, regardless of legal form, that are deemed tax resident in a Member State (although in practice a limited partnership would not itself be subject to the directive because it is not “tax resident” anywhere).

Next steps

Ambitiously, the directive is intended to take effect from 1 January 2024, however, it requires unanimity from all Member States before adoption. Recognising this is a challenging timeframe, an amendment is proposed for the initiative to start 12 months later on 1 January 2025. It is likely that the directive will need material changes before it is endorsed unanimously and so an extension even beyond this feels a likely outcome. 

Following the consultation that ended in April 2022 we understand work is underway to produce a compromise text of the directive that takes on board points of concern from Member States and points raised by stakeholders in the consultation. This has so far proved a slow process and work is likely to slip into the Swedish Presidency, but a more likely prospect is under the Spanish Presidency in the latter part of 2023.

Given that the directive is not anticipated to move forward particularly swiftly this will no doubt push the commencement date. However, it is worth being aware that irrespective of the commencement date, the current draft includes a retrospective look-back period for certain tests which means groups will need to be ready to evaluate current structures and operations that might be caught within scope. 

This article was published on 16 December 2022.