ATAD 3: the new challenge ahead

  1. Introduction

In December 2021, the European Commission issued a proposal to prevent the misuse of shell entities for tax purposes (in the form of a proposed EU directive[1] referred to as “ATAD 3”), which is intended to come into effect from 1st January 2024.

The recent Proposal for a new Directive (referred to as well as UNSHELL Directive) seeks to address the misuse of investment structures that “do not perform any actual economic activity,” commonly known as shell companies. The proposed Directive is aimed at EU resident holding companies that claim benefits under double tax treaties and other EU directives but lack minimum economic substance.

This is not the first time in recent years that there has been an increased focus on holding companies or companies with no substance and nexus with their territory of residence following the Principal Purpose Test (PPT) introduction into DTTs. Besides the PPT, recent EU case law also tends to deny companies with no or minimal economic activity access to EU directives.

  1. Scope of the Directive

The draft Directive focuses specifically on legal entities, irrespective of legal form (i.e. including legal arrangements such as partnerships); are tax residents in the EU, who are involved in cross-border activities and are eligible to receive a tax residency certificate in a Member State (MS).

The draft Directive outlines gateway indicators that help determine whether an undertaking is “at-risk” of being a shell company. If these indicators are met, the undertaking will be considered “at-risk” and be subject to further reporting to determine that it meets “minimum substance” requirements.

Access to double tax treaties or EU Directives will be disallowed if an undertaking qualifies as a shell for tax purposes. Transparency is further increased through the automatic exchange of information on any undertaking that is at risk of being a shell, which would enable the Member States to request the Member State of the undertaking to conduct a tax audit.

  1. Steps to be followed

The Proposal contains a series of steps that should determine whether an entity qualifies as a shell and the consequences.

3.1 Carve-outs

For tax certainty, undertakings performing certain activities are carved out explicitly and therefore considered low-risk and outside the Directive’s scope.

The Proposal has carve-out provisions excluding undertakings listed on a regular stock exchange, regulated financial undertakings, and undertakings with the main activity of holding shares in operational businesses in a domestic context, provided that their beneficial owners are also resident for tax purposes in the same Member State (domestic holding situations), undertakings with holding activities that are resident for tax purposes in the same Member State as the undertaking’s shareholder(s) or the ultimate parent entity (sub-holding situations) and undertakings with at least five full-time equivalent employees carrying out income-generating activities.

While these exclusions should cover companies that list their notes, UCITS and companies established as Alternative Investment Fund (AIF) managed by an AIF Manager (AIFM), as well as entities covered by the EU directives[2] and regulations[3], it remains to be seen what the fate for AIFs with multiple compartments (Umbrella Fund) will be.

Undertakings that fall in the scope of any of the carve-outs do not need to consider whether or not they cross the gateways.

3.2 Gateways

The first step divides the various types of undertakings into those at risk for lacking substance and being misused for tax purposes and those at low risk. Risk cases present simultaneously several features usually identified in undertakings that lack substance.

These criteria are commonly referred to as ‘gateway.’ Low-risk cases present none or only some of these criteria, i.e., those that do not pass the gateways.

The draft Directive lays down three “gateway” criteria which, if cumulatively met, will require an undertaking “at-risk” to report. The criteria link to (i) relevant income, i.e., if more than 75% of the entity’s revenues over the last two years is passive income such as interest, dividends, and income from the disposal of shares or income from immovable property (or in the absence of income where private equity / real estate investments represent more than 75% of the total book value); (ii) engagement in cross-border activities with a threshold of 60% of the book value of certain assets located or relevant income derived from abroad; and (iii) outsourcing of own administration, i.e., whether in the preceding two years, the entity outsourced the administration of day-to-day operations and the decision-making on significant functions to trust and company service providers.


Only the undertakings considered at risk at the first step proceed to the second step, which is the core of the substance test itself. Since they are at risk, these undertakings are asked to report their substance in their tax return. Reporting on substance means providing specific information, normally already arising from the undertaking’s tax return, in a way that facilitates the assessment of the activity performed by the undertaking. The focus is on specific circumstances normally present in an undertaking that performs a substantial economic activity.

Three elements are considered important: first, premises available for the exclusive use of the undertaking; second, at least one own and active bank account in the Union; and third, at least one director resident close to the undertaking and dedicated to its activities or a sufficient number of the undertaking’s employees that are engaged with its core income-generating activities being resident close to the undertaking.

Taking a first look at the structures of Cyprus, often holding companies are set up to hold assets, mainly share participation (for commercial reasons and/or having access to Cyprus’s network of double tax treaties and/or EU Directives benefits). Looking at the gateway tests, such holding companies will meet the relevant income and the cross-border activities criteria. With respect to the outsourcing of own administration and decision-making, the draft Directive does not elaborate much. However, the Preamble clearly refers to situations where an entity relies on professional third-party service providers for the supply of administration services in order to set up and maintain a legal and tax presence.

Most of the Cypriot holding companies outsource their daily operations and their decision-making to Administrative Service Providers (ASPs) and should therefore pass each of these gateways: they would then be considered at risk, which will trigger a reporting obligation.

Undertakings that do not outsource the day-to-day administration or the decision-making should, on the other hand, not be in the scope of ATAD 3 (“low-risk” entities). The agreement with affiliated companies to provide such support is not explicit whether it will be considered as outsourcing of significant decisions and remains to be clarified.

3.3 Exemption upon request

In recognition that substance is ultimately a matter of facts and circumstances, the Directive includes a mechanism allowing taxpayers to challenge the test outcome therein, including by evidencing the commercial, non-tax motives underlying a certain structure. In the same vein, structures that are not put in place with the main purpose of obtaining a tax advantage may avail of a mechanism to reqest an upfront exemption.

An entity considered “at-risk” (crossed the gateway) and having to report can still demonstrate that its existence does not create any tax benefit for itself, the group of companies of which it is a member, or for the ultimate beneficial owner(s). Effectively, this means that the entity must provide evidence to the tax administration of its place of tax residence that allows comparing the overall tax burden of the beneficial owner(s) or the group as a whole, with and without the entity’s interposition. Suppose the tax administration concludes that the evidence satisfactorily demonstrates the lack of tax motives; it can grant the entity an exemption that may be valid for a maximum period of six years.

Article 10 of the Directive provides that a Member State shall take the appropriate measures to allow an undertaking that meets the criteria laid down in Article 6(1) to request an exemption. Practically, even though in the Directive there are no specific steps to be followed, it is expected that all MS will apply the same procedures for securing such exemption.

3.4 Rebuttal

The fifth step involves the right of the undertaking which is presumed to be a shell and misused for tax purposes, for the purposes of the Directive, to prove otherwise, i.e., to prove that it has substance or, in any case, it is not misused for tax purposes. This opportunity is very important because the substance test is based on indicators and, as such, may fail to capture the specific facts and circumstances of each individual case. Taxpayers will therefore have an effective right to make the claim that they are not a shell in the sense of the Directive.

The evidence produced is expected to include information on the commercial (i.e., non-tax) reasons for setting up and maintaining the undertaking, which does not need own premises and/or bank account and/or dedicated management or employees. It is also expected to include information on the resources that such undertaking uses actually to perform its activity. It is also expected to include information allowing for verifying the nexus between the undertaking and the Member State where it claims to be resident for tax purposes, i.e., to verify that the key decisions on the value-generating activities of the undertaking are taken there.

3.5 Tax Consequences

Once an undertaking is presumed to be a shell for the purposes of the Directive and does not rebut such presumption, tax consequences should kick in. These consequences should be proportionate and aim at neutralizing its tax impact, i.e., disallowing any tax advantages which have been obtained, or could be obtained, through the undertaking in accordance with agreements or conventions in force in the Member State of the undertaking or relevant EU directives, in particular, Council Directives 2011/96/EU on the common system of taxation applicable in the case of parent companies and subsidiaries of different Member States and 2003/49/EC on a common system of taxation applicable to interest and royalty payments made between associated companies of different Member States. These advantages would be, in effect, disallowed if the relevant agreements, conventions, and EU directives were disregarded with regard to the undertaking that was found not to have minimum substance and did not prove the contrary.

The other Member States, by denying access to the benefits under tax treaties and EU Directives to the shell company, will disregard the shell company so as to tax its relevant income as if it had accrued directly to the shell company’s shareholder(s). It should be noted that the shell company will remain taxable in its Member State of establishment and thus will have to fulfill all relevant tax obligations, irrespective of any taxation of its relevant income in the Member State of tax residence of its shareholder(s) and/or the Member State of a company making payments to it.

  1. Summary

The recent Proposal for a new Directive is another stepping stone to the ambition of the Commission to provide a fair and sustainable European business tax system and to support the public revenues for the Member States. The legal basis for the draft Directive is stated to be Article 115 of the Treaty on the Functioning of the European Union (TFEU), which states that “…the Council shall…issue directives for the approximation of such laws, regulations or administrative provisions of the Member States as directly affect the establishment or functioning of the internal market.” One could question, not unreasonably, whether this draft directive could be considered to have a direct impact on the establishment or functioning of the internal market.

There are numerous reasons why MNEs use intermediate holding companies: segregation of assets and risks, structuring for pledge, segmentation of activities by geographical areas, currency, or other criteria are some of the legal and commercial motives that justify relying on several layers of companies. As a result, it may be possible to rebut the presumption of being a shell.

If the draft directive is implemented in its current form could significantly affect ASPs as they will not be able to provide multiple directorship services. To show minimum substance, independent directors must hold only one directorship and must be residents close to the undertaking. This is contrary to Companies’ laws and regulations that permit directors appointed and perform their functions and exercise their duties to more than one entity.

It also seems contrary to the fundamental freedoms of the European Union – free movement of people and capital and freedom of establishment.

  1. Next steps

The Directive will be entered into force on 1st January 2024, BUT there is two years reference period (1st January 2022 – 31st December 2023. Therefore undertakings operating legitimately right now could already be inadvertently coming within the scope of the draft Directive when/if it is implemented in 2024. Additionally, we should mention that although the draft directive targets EU shells, the Commission has made it clear that it will adopt another regulation to deal with non-EU shells in 2022.

Holding companies are well-advised to pay particular attention to the draft Directive and to carry out an initial impact assessment on their corporate structures, even if the draft Directive is planned to be effective only on 1st January 2024. Given that the gateway criteria refer to the preceding two tax years, the way of setting up and operating holding companies from the tax year 2022 will already influence what impact the provisions of the draft Directive will finally have in 2024.

…… Be “prudently watchful and discreet in the face of danger or risk.”

[1] Directive 2011/16/EU (COUNCIL DIRECTIVE laying down rules to prevent the misuse of shell entities for tax purposes and amending)

[2] Directive 2014/65/EU, Directive 2011/61/EU, Directive 2009/65/EC, Directive 2009/138/EC, Directive 2009/138/EC, Directive 2016/2341.

[3] (EU) No 575/2013, (EU) No 345/2013, (EU) No 346/2013, (EU) 2015/760, (EC) No 883/2004, (EC) No 987/2009, (EU) No 909/2014.

Costas Savva
T: +357 22 875 720