You may have heard about Pillar Two, and you may have also heard that the Netherlands, as the first country in the EU, published Pillar Two draft legislation on October 24^th, 2022. This draft will now be updated following a round of public consultation, after which the amended draft legislation will be presented to the Dutch Parliament, with the aim to get it implemented and effective by the start of 2024. Now you may be wondering what this is all about, if and when this is actually going to happen, and whether you should care – below we summarize, visualize & cover some FAQs on Pillar Two general systematics and the Dutch draft rules.

FAQs: Pillar Two in general

What is Pillar Two again?

Pillar Two is part of a two-pillar solution resulting from the OECD’s BEPS Action 1 (set back in 2015), calling to address the tax challenges arising from the digitalization of the economy. Per October 2021, over 135 jurisdictions have signed on to the statement on the Two-Pillar Solution to Address the Tax Challenges Arising from the Digitalisation of the Economy, to reform the international tax system in light of this ongoing increasing digitalization.

In short, Pillar One aims to realign taxing rights towards ‘market jurisdictions’ where MNEs lack a physical presence, and Pillar Two aims to ensure that a minimum level of tax is paid, addressing the challenges of the digitalizing economy where the relative importance of intangible assets as profit drivers may still leave room for profit shifting planning.

What are the basics of Pillar Two?

To put it in a nutshell (with reference to the following questions for further details):

What is Pillar Two trying to achieve?

Pillar Two is designed to ensure that MNEs pay a minimal level of tax in every jurisdiction in which they have a taxable presence, therewith also lowering the incentive for MNEs to ‘shift’ profits to lower tax jurisdictions, for example through moving IP or other tangible assets to those jurisdictions. The minimum level of tax is set at a rate of 15% over a ‘common’ tax base determined based on the Pillar Two rules.

Where do we stand today?

While originally presented as a combined ‘two-pillar solution’, the implementation of each Pillar is now following a different track and it seems likely, at least in a number of jurisdictions, that implementation will take place separately. In December last year (2021), the OECD/IF released its first draft of the Pillar Two ‘Model Rules’, closely followed by the European Commission releasing its (largely similar) draft Pillar Two Directive. These drafts, once finalized, are meant to serve as a template for the implementation into domestic law.

Although Pillar Two was initially back on the agenda for the last Ecofin meeting on December 6th, 2022, the draft EU Directive has still not been adopted, as the required unilateral agreement by all EU Member States has not yet been reached. Recently, however (September 2022), a joint statement was issued by the governments of France, Germany, Italy, the Netherlands, and Spain, reconfirming their commitment to the implementation of the global minimum tax (essentially Pillar Two). Following that statement, as mentioned, the Netherlands is now the first of these five to have published its draft Pillar Two legislation, with intended implementation for financial years starting on or after 12/31/2023.

Will it apply to me?

The Pillar Two rules apply to entities that are part of an MNE Group with an annual revenue of at least EUR 750 Million based on an Accepted Financial Accounting Standard (similar to the threshold for the existing Country-by-Country Reporting or ‘CbCR’ rules). To be in scope, the Ultimate Parent Entity (‘UPE’) of the MNE Group must meet the revenue threshold on a consolidated basis for at least two of the four years immediately preceding the relevant fiscal year. The UPE is described as an entity that has a Controlling Interest -directly or indirectly- in any other Entity (and is itself not owned -directly or indirectly- by another entity with a Controlling Interest in it). A Controlling Interest is a recurring term in the Pillar Two rules and is defined as an Ownership Interest in an Entity for which the interest holder is -or would have been- required to consolidate the assets, liabilities, income, expenses, and cashflows of the Entity. In addition, a Main Entity is deemed to have the Controlling Interest in its Permanent Establishments, based on which the Model Rules also apply to companies with Permanent Establishments in one or more jurisdictions. Certain entities, such as NGOs, Investment Funds, and Pension Funds, are excluded from the Pillar Two rules.

How is the ETR for Pillar Two calculated?

The ETR of an MNE under Pillar Two rules is determined by dividing the amount of ‘Covered Taxes’ by the amount of income as determined under the Pillar Two rules. In short, Covered Taxes include any tax on an entity’s income or profits (including a tax on distributed profits) and include any taxes imposed instead of a generally applicable income tax. Covered taxes also include taxes on retained earnings and corporate equity. The MNE’s income is calculated starting with the standalone financials of group entities (or permanent establishments) determined under the same accounting standards as the consolidated financial statements at UPE level, i.e. the Financial Accounting Net Income before consolidation to eliminate intra-group transactions. Subsequently, certain adjustments (some mandatory, some elective) are to be made in order to align the determination of the income base better with common (tax) standards.

Once the Covered Taxes, as well as the (adjusted) income (or loss), has been determined under the Pillar Two rules, these amounts are grouped for all in-scope entities (or permanent establishments) within the same jurisdiction (with certain consolidation eliminations for income/loss of entities in tax groups in the same jurisdiction) to eventually determine the Pillar Two ETR for that jurisdiction. Note that when calculating the ETR, the taxable income for a jurisdiction may be lowered with a substance-based carve-out (a percentage of payroll costs and tangible asset value) to allow for a fixed return for ‘real economic activity’ to be out of scope.

Finally, the amount of Top-Up Tax for each group entity is equal to the difference between the ETR and the minimum ETR under the Pillar Two rules, multiplied by the adjusted income of the group entity.

So why can’t I just use my existing ETR calculations?

Although these can be a good starting point, the ETR for purposes of the Pillar Two rules may be different in some cases as it is calculated based on a new set of rules determining which income (or loss) and which taxes should be taken into account as described above.

To get into the details a bit – the rules based on which we determine what goes into the ETR calculation in terms of taxes and income for Pillar Two purposes are different from the rules used for the existing ETR calculations. And although there are quite some similarities, there can also be some differences that could lead to a different ETR for Pillar Two, for example:

• A different starting point is used for determining the taxable income – i.e. the commercial financial numbers for each in-scope entity (or permanent establishment) as used in the preparation of the UPE’s consolidated financial statements (before consolidation adjustments to eliminate intra-group transactions).

• Different adjustments may be made to get from commercial income to (Pillar Two) taxable income – examples include net tax expense, dividends and capital gains from certain subsidiaries, arm’s length adjustments, consolidation eliminations for entities in tax groups in the same jurisdiction, exclusions for income derived from shipping, etc. Although some of these look similar to what we’re used to, some may differ or apply under different conditions. Moreover, certain adjustments that are made for local tax purposes today, like the innovation box regime in the Netherlands, do not exist under the Pillar Two rules.

• Deferred taxes are subject to certain adjustments under the Pillar Two rules – for example, deferred tax expenses are calculated at a maximum rate of 15%, and so-called recapture rules could take back the deferred tax -with some exceptions- if the deferred amount is not paid within five subsequent fiscal years.

If there is any top-up tax due, how and where will this be collected?  

The key systematics of Pillar Two have been designed to include a main ‘top-down’ rule, the Income Inclusion Rule (‘IIR’), and a backstop rule, the Undertaxed Profit Rule (‘UTPR’). The IIR imposes a Top-Up Tax on the UPE with respect to low-taxed income (below 15%) of a foreign subsidiary or permanent establishment (comparable to a sort of CFC rule). The UTPR acts as a backstop rule to collect any top-up tax that is not collected under the IIR, and is effectuated through the denial of deductions (or other profit adjustments) applied by the (lower-tier) group entities in other jurisdictions that have implemented the UTPR (divided based on the number of employees and tangible asset value in the UTPR jurisdictions).

Next to the IIR and UTPR, the OECD and EU Pillar Two draft rules however also leave room for so-called Qualified Domestic Minimum Top-up Taxes (‘QDMTT’) which, if imposed, lower the top-up tax to be collected under the IIR and UTPR. As this QDMTT allows jurisdictions to collect the additional tax determined under Pillar Two rules themselves instead of potentially having other jurisdictions do so under the IIR or UTPR, it is expected that a lot of jurisdictions will introduce such a domestic tax, meaning that the collection of the top-up tax will, in that case, happen in the jurisdiction where the Pillar Two ETR is below 15%. Refer to the below visual for some simplified examples of how the IIR, UTPR and QDMTT could apply.

Looking at these systematics, it is rather crucial that the rules are implemented consistently across jurisdictions, producing the same overall result to ensure that the MNE Group is subject to a minimum level of taxation in each jurisdiction without exposing it to the risk of double taxation. Although the OECD and EU drafts aim to facilitate such consistency, local implementations may still differ in terms of exact rules or interpretation/application thereof.

FAQs: the Dutch Pillar Two draft legislation

What is the current status of the implementation of the rules?

Following the publication of the draft rules and the closing of the public consultation round, the draft proposal will now be updated and then presented to the Dutch Parliament, where the legislation will be discussed in both Houses. The rules are then intended to be finalized and implemented during the course of 2023 to start applying for financial years starting on or after December 31, 2023 (and December 31, 2024 for the UTPR).

What about the proposed EU Pillar Two Directive?

The Dutch draft legislation is meant to implement the proposed EU Pillar Two Directive (specifically the compromise text of June 16, 2022). Even though agreement at EU level has not yet been reached, the Dutch government still favors a common EU approach. The joint statement brought out together with France, Germany, Italy and Spain in September this year reconfirms the wish to reach agreement at EU level and therewith the commitment of the Netherlands to implement the Directive timely. The Dutch government indicated the draft legislation can form the basis for definitive proposed legislation, whereby EU developments are monitored closely.

How will the draft legislation be incorporated into the Dutch tax legislation?

To implement the rules in its domestic legislation, the Netherlands has chosen to create a separate tax act in addition to its current Corporate Income Tax Act (‘CITA’). The reason for having a new and separate act is primarily to avoid adding complexity to the current CITA.

Did the Netherlands opt for the QDMTT?

The Dutch draft legislation includes the optional QDMTT. The QDMTT aims to ensure that the Netherlands will be able to collect the Top-Up Tax of Dutch-based low-taxed entities (or permanent establishments) locally in the scenario the parent entity is not located in the Netherlands. If the Dutch domestic rules qualify as a QDMTT, a UPE located in another jurisdiction is, in principle, obliged to give a credit for the top-up tax collected under the Dutch QDMTT (we refer to the explanation above).

What is considered an MNE group?

An MNE group is a group of entities that are connected by ownership or control. The Pillar Two rules are linked to the group concept in the accounting standard rules as applied at UPE level when drawing up the consolidated annual accounts. The second form of an MNE group could be an entity with one or more permanent establishments – provided that the entity is not already part of an MNE group.

What if the company only has a presence in one jurisdiction?

In that case, the company can still qualify as a large-scale domestic group, which is in principle also in-scope of the Pillar Two rules.

What is considered to be a group entity?

The Dutch draft legislation identifies three types of group entities:

• An entity that is part of an MNE group;
• An entity that is part of a large-scale domestic group; and
• A permanent establishment of an entity that is part of an MNE group.

Is a permanent establishment considered an entity?

A permanent establishment is treated as a separate group entity for purposes of the Dutch Pillar Two rules. This ensures that the income derived by the permanent establishment is not included in the calculation of the ETR in the jurisdiction of its Parent.

Must the entity have a legal personality?

An ‘entity’ is treated as such if it has legal personality and/or if it prepares financial statements, which is also the case for partnerships or trusts. It is, therefore, not necessarily required to have legal personality. Individuals do not fall under the definition of ‘entity’.

Are dividends (or other benefits) derived from subsidiaries included as income for the ETR calculation?

The rules deviate from the existing rules of the Dutch participation exemption in the CITA. Where the Dutch participation exemption generally excludes dividends and capital gains derived from qualifying subsidiaries in which ownership interests of 5% or more are held without a minimum holding period, the draft Dutch Pillar Two rules only allow for the exclusion of dividends and other income derived from a subsidiary if the ownership interest in that subsidiary is 10% or more and/or if the subsidiary has been held for at least a year. Based thereon, the taxable income under the Dutch CITA could look different from the income under the Dutch Pillar Two rules.

Another example of where the rules deviate is in relation to liquidation losses, which can under circumstances be taken into account when determining the taxable income under the Dutch CITA, while such losses are not taken into account under the Dutch Pillar Two rules.

Do the Pillar Two rules impact the application of the Dutch Innovation Box?

The innovation box effectively lowers the CIT rate from 25.8% to 9% for income derived from qualifying innovative activities. As a result, companies applying the innovation box may have a lower ETR in comparison to other companies. Although the Pillar Two rules will not impact the application of the Dutch innovation box as such, the effectiveness may be impacted by the Pillar Two rules if these would result in additional taxation up to the 15% minimum tax level. It is, however, expected that in most cases, the application of the Innovation Box will not result in an overall ETR of less than 15% (on a blended basis, seeing as the Dutch headline rate is 25.8% and generally only part of the revenue of a company is attributable to the innovation box). Therefore, it is not expected that this will impact many Dutch-based companies according to the explanatory statements to the Dutch draft Pillar Two legislation.

What will the compliance process of the new Pillar Two Act look like?

It is proposed that the in-scope Dutch-based UPE or group entity of an MNE should file a Pillar Two specific top-up tax information return separate from the actual top-up tax return. This top-up tax information return should contain the calculation of the top-up tax and the distribution thereof across the jurisdictions. Following the initial year in which the Pillar Two rules take effect in the Netherlands (likely 2024), a Netherlands-based UPE or MNE group entity has 18 months to file the top-up tax information return. Two months later, the consequent Pillar Two top-up tax return and payment term end, i.e. 20 months following the end of the initial year. In the second year (likely 2025), the information return should be filed within 15 months after the end of the second year, and the top-up tax return and payment term end 17 months following the end of the second year. As such, there is a bit more runway for taxpayers to allow for sufficient time to process the complex Pillar Two top-up tax information return calculations in a proper top-up tax return.

Want to know more? Schedule a meeting below – it’s on us!

On Thursday the 20^th of January 2022 the Organisation for Economic Co-operation and Development (also known as: ‘OECD’)  released an update to the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. This update mainly incorporates earlier released documents, but it also makes some consistency changes to the OECD Transfer Pricing Guidelines of 2017. These consistency changes were needed to produce the consolidated version of the Transfer Pricing Guidelines and were approved by the OECD/G20 Inclusive Framework on BEPS on the 7^th of January 2022.

The following documents are incorporated in the Transfer Pricing Guidelines 2022:

• The 2018 ‘Revised Guidance on the Application of the Transactional Profit Split Method’;
• The 2018 ‘Guidance for Tax Administrations on the Application of the Approach to Hard-to-Value Intangibles’; and
• The 2020 report ‘Transfer Pricing Guidance on Financial Transactions’

Revised Guidance on the Application of the Transactional Profit Split Method

The guidance set out in this report responds to the mandate under Action 10 of the BEPS Action Plan, which requires the development of:

“rules to prevent BEPS by engaging in transactions which would not, or would only very rarely, occur between third parties. This will involve adopting transfer pricing rules or special measures to: … (ii) clarify the application of transfer pricing methods, in particular profit splits, in the context of global value chains”

Since 2010, the Transfer Pricing Guidelines states that the most appropriate method should always be used. This method can be (among others) the profit split method. This revised guidance provides clarification and significantly expands the guidance on when a profit split method may be the most appropriate method. It describes certain indicators such as the unique and valuable contributions each party makes to the transaction and the share of economically significant risk. Furthermore, the revised guidance includes several examples illustrating the principles discussed.

Guidance for Tax Administrations on the Application of the Approach to Hard-to-Value Intangibles

BEPS Action 8 addresses transfer pricing issues to controlled transactions involving intangibles, since intangibles are by definition mobile and they are often hard-to-value which makes base erosion and profit shifting possible. The OECD states that misallocation of these profits has heavily contributed to base erosion and profit shifting.

The hard-to-value intangibles approach disarms the negative effects of information asymmetry, by ensuring that tax administrations can consider ex post outcomes as presumptive evidence about the appropriateness of the ex-ante pricing arrangements. I.e. administrations can take later outcomes in consideration of the earlier dealt with pricing agreement. At the same time, taxpayers have the possibility to rebut such presumptive evidence by demonstrating the reliability of the information supporting the pricing methodology adopted at the time of the controlled transaction took place. This is to prevent later information to rule over the earlier information, which would certainly subvert the legal security of the taxpayer.

The guidance aims at reaching a common understanding and practice among tax administrations on how to apply adjustments resulting from the application of the hard-to-value intangibles approach. The guidance should improve consistency and reduce the risk of economic double taxation.

Transfer Pricing Guidance on Financial Transactions

The 2020 report on financial transactions pertains to Action 4 and provides guidance in the accurate delineation of financial transactions, particularly in capital structures of multinational enterprises. Furthermore, it analyses the pricing of a controlled financial transaction. The report describes the transfer pricing aspects of financial transactions such as intra-group loans, treasury functions, cash pooling, hedging, guarantees and captive insurance.

Action 4 constitutes the limitations on interest deductions, and aims to limit base erosion through the use of interest expenses to achieve interest deduction or to finance the production of exempt or deferred income.

What’s happening?

On the 22th of December, the European Commission (hereinafter: ‘EC’) has presented an initiative to combat the misuse of shell entities for improper tax purposes (‘ATAD 3’). This proposal will ensure that shell companies in the EU with no- or minimal economic activity are unable to benefit from any tax advantages, consequently discouraging their use. Furthermore, the Commission Ter Haar published a report on ‘doorstroomvennootschappen’ in the Netherlands last October.

Shell companies can be used for aggressive tax planning or tax evasion purposes. Businesses can direct financial ‘flows’ through these shell entities towards tax friendly jurisdictions. Similar with this, some individuals can use shell entities to shield assets – more specific real estate – from taxes, either in their respective home country or in the country where the property is located. The main purpose of this proposal is therefore to address the abusive use of so-called shell companies, being referred to as legal entities with no, or only minimal, substance and economic activity.

History intermediary holding companies

International groups often use intermediate holding companies to hold shares in subsidiaries organized on a regional or divisional basis. Furthermore, holding companies are often used as the vehicle for investing in portfolio companies in a private equity context. In past times, it was not particularly controversial that holding companies were entitled to the potential benefits of tax treaties and potential directives in their country of residence. This would frequently restrict the right of investee jurisdictions to tax dividends and gains derived by the holding company from its local subsidiaries. As shown in the timeline underneath, the perception and position of these companies has changed, with an accumulation of measures that potentially restrict the access to the benefits and directives.

This all started with the introduction of the term “beneficial ownership” into the OECD’s Model Tax Convention in 1977. The question was asked: who does actually benefit from this/these payment(s)? Whilst being slightly controversial in the 70’s, the term now appears in most tax treaties and intents to prevent treaty shopping by ensuring that the benefits of the dividends, royalties and interest articles are only accessible to residents of the contracting state that are the beneficial owners of the payment. After this, the OECD’s report on the use of conduit companies in 1986 ruled conduit companies out of the beneficial ownership regard. Nevertheless, there was no generally agreed definition of the term ‘beneficial ownership’ in tax treaties and the interpretation would follow the domestic law of the contracting states. The first hint of an international fiscal meaning of this term stems from the Indofood case (Indofood International Finance Ltd. V JP Morgan Chase Bank NA, 2006). To prevent falling foul of the beneficial ownership test, certain groups reviewed their holding structure(s) and looked to eliminate fully back-to-back financing arrangements. Furthermore, some structures which involved payment chains were set up with an “equity gap”. These structures reflected a widespread view that beneficial ownership was an objective test that was indifferent to the motives behind these holding company arrangements.

Whilst having a long history, reverting back to said changes in the OECD model treaty in the 70’s, the real challenge to the treaty status of holding companies began in 2015, when the Base Erosion and Profit Shifting project (‘BEPS’) recommended measures to restrict inappropriate usage of tax treaties. The bar is consequently set higher and higher for the criteria that holding companies need to meet in order to benefit from relief from withholding taxes and exemptions to non-resident capital gains tax. The high apex for this approach is the just published proposal to end the misuse of shell entities. Some of the statements suggest that it may never be appropriate for an intermediate holding company (using the term ‘shell entity’) to benefit from reductions in withholding taxes under tax treaties and EU directives.

The Dutch government already set up a commission that investigated the use of the so-called shell companies and their potential misuse of the Dutch tax system. This report was published last October.

Dutch investigation on shell companies (Commission Ter Haar)

‘Doorstroomvennootschappen’ (as they’re often referred to in Dutch) provide little benefit to the Dutch economy, disadvantage developing countries disproportionately through loss of tax revenue for developing countries in particular, and the phenomenon damages the reputation of the Netherlands. These are the main conclusions of the Committee on Flow-through Companies, chaired by Mr. Ter Haar, which presented its final report recently.

The committee describes the relevant components of the Dutch tax system that, at least until recently, have made the Netherlands attractive to flow-through companies. These include the participation exemption, the extensive treaty network, the absence of a withholding tax on interest and royalties and the ruling practice. The report describes examples of unintended use of each of these aspects of the Dutch tax system. In combination with the well-organized financial advice and services sector, this has led, according to the Committee, to a sizeable financial flow. The Committee believes that the measures already taken are expected to put an end to (part of) the tax-driven flow of interest and royalties. This does not mean that the Netherlands should be expected to lose its position as a country of establishment for empty holding companies, even though the Dutch tax system is no longer unique compared to other countries. According to the Committee there will still be a large group of (almost) empty conduits that make use of the Dutch tax infrastructure, whose contribution to the economy is small. The Committee therefore recommends further steps, but at the same time sees that far-reaching unilateral measures do not immediately offer a solution. In the first place, the Committee recommends a proactive attitude and a pioneering role with respect to international and European initiatives. These include the revision of the international tax system within the Inclusive Framework of the OECD and the announced EU Directive proposal on flow-through companies. According to the committee, the Netherlands should advocate measures that involve both the targeted exchange of information and to limit the benefits of the Interest and Royalties Directive and the Parent-Subsidiary Directive.

The advantage of this structure is that the dividends, by making use of the Dutch treaty network, without or with reduced withholding of local tax, arrive at the company in the country of residence (Country A), without or with reduced withholding of local tax, compared to the situation where the payment is made directly to the country of residence (Country A) by the source country (Country C). This is just one example of a (flow-through) structure in which the Dutch treaty network plays a role, in combination with the participation exemption and the dividend withholding tax exemption in treaty situations.

Because the Netherlands has long had a large bilateral tax treaty network, the Netherlands is an attractive country for ‘treaty shopping’. When the tax treaties are concluded, it is assumed that it is up to the source country to prevent the reduced rate of withholding tax, which is wrongly applied mostly.

Unilateral measures cannot prevent other countries from playing the role as flow through country. To avoid international tax avoidance through ‘empty entities’, international agreements are therefore necessary. The committee lastly advises also a constructive attitude by the Netherlands to the ongoing initiatives of the European Commission.

ATAD 1-2

The public perception of tax evasion has shifted in recent years, by taking a drastic turn. In particular, the credit crisis of 2008 has changed the social acceptance of tax avoidance by multinationals in particular. With government deficits and rising government debt, it was considered unfair that a number of multinationals paid (relatively) little tax on their world profits.

This all accumulated into a public hearing of officials of Amazon, Google and Starbucks organized by the Public Accounts Committee in the UK in 2012. The committee chair Ms. Hodge said (the later iconic words):

“We’re not accusing you of being illegal, we’re accusing you of being immoral”.

This all led to the BEPS-project and consequently ATAD. There have been 2 Anti-Tax-Avoidance-Directives already put into effect. ATAD 1 introduced 5 sets of minimum standards (interest limitation rule, GAAR, CFC rules, hybrid mismatches and exit taxation). In the second ATAD, subsequent rules relating to hybrid mismatches were finalized on 29 may 2017 when the ECOFIN accepted this directive. ATAD is based on Article 115 of the Treaty on the Functioning of the EU (‘TFEU’).

ATAD 3

Shell Companies

The definition of the widespread term ‘shell’, often interchangeably with terms such as ‘letterbox’, ‘mailbox’, ‘special purpose entity’, special purpose vehicle’ and similar, is defined differently in different contexts. For the purpose of ATAD 3, shell companies refer to three types of shell companies:

• Anonymous shell companies
• Letterbox companies
• Special purpose entities

The main common feature of the above three types is the absence of real economic activity in the Member State of

registration, which usually means that these companies have no (or few) employees, and/or no (or little)

production, and/or no (or little) physical present in the Member State of registration

What will change?

The proposed rules will establish transparency standards around the use of shell entities, so that their abuse can be detected more easily by tax authorities. Using a number of objective indicators related to income, staff and premises, the proposal will help national tax authorities detect entities that exist merely on paper.

The proposal introduces a filtering system for the entities in scope, which have to comply with a number of indicators. These different levels constitute a type of gateway. This proposal sets out three gateways. If an entity crosses all three gateways, it will be required to annually report more information to the tax authorities through its tax return.

Gateways

First gateway

The first level looks at the activities of the companies based on the income they receive. This gateway is met if >75% of an entity’s overall revenue in the last two tax years does not derive from the entity’s business activity or if more than 75% of its assets are real estate or other private property of particularly high value.

Second gateway

The second level requires a cross-border element. If the entity receives the majority of its relevant revenue through international transactions linked to another jurisdiction or passes this relevant income on to other entity’s situated abroad, the entity passed to the next and last gateway.

Third gateway

The third, and last, level focuses on whether corporate management and administration services are performed in-house or are outsourced.

Crossed all gateways?

An entity crossing all levels will be obliged to report information in its tax return related to the premises of the entity, its bank accounts, the tax residency of its directors and employees etc. These are the so-called substance requirements. All declarations should be accompanied by supporting evidence. If one of the substance requirements isn’t met, the entity will be presumed to be a ‘shell company’.

When will the proposal come into force?

Once adopted by the Member States, the Directive should come into effect on 1 January 2024.

Rebuttal arrangement?

If the substance criteria are not met, entities still have the opportunity to rebut the presumption of being a shell. Additional evidence needs to be presented, such as detailed information about the commercial, non-tax reason of their establishment, the profiles of their employees and the fact that decision-making takes place in the Member State of their tax residence.

Tax Consequences

If an entity is deemed to be a shell company, the benefits and reliefs of the tax treaty network of its Member state are not applicable. Furthermore, the company will not be able to qualify for the treatment under the Parent-Subsidiary and Interest and Royalty Directives. To support the implementation of these consequences, the Member State of residence of the company will either deny the shell company a tax residence certificate or the certificate will specify that the company is a shell.

Furthermore, payments to third countries will not be treated as flowing through the shell entity, and will be subject to withholding tax at the level of the entity that paid to the shell. According with this, inbound payments will be taxed in the state of the shell’s shareholder. Relevant consequences will apply to shell companies owning real estate assets for the private us of wealthy individuals and which as a result have no income flows. Such real estate assets will be taxed by the state in which the asset is located as if it were owned directly by the individual.

Scenario 1 EU source jurisdiction of the payer – EU shell jurisdiction – EU shareholder jurisdiction

In this case, all three jurisdictions fall in the scope of the Directive and are consequently bound by ATAD3:

• EU subsidiary: this entity will not have a right to tax the payment, but may apply domestic tax on the outbound payment to the extent it cannot identify whether the undertaking’s shareholder is in the EU.
• EU shell: this entity will continue to be a resident for tax purposes in the respective Member State and will have to fulfil relevant obligations as per national law, including by reporting the payment received; it may be able to provide evidence of the tax applied on the payment.
• EU shareholder: this entity will include the payment received by the shell undertaking in its taxable income, as per the national law and may be able to claim relief for any tax paid at the source, including by virtue of EU directives. It will also take into account and deduct any tax paid by the shell.

Scenario 2 Non-EU source jurisdiction of the payer – EU shell jurisdiction – Non-EU shareholder jurisdiction

• Third country subsidiary: may apply domestic tax on the outbound payment or can decide to apply tax according to the tax treaty in effect with the third jurisdiction of the shareholder if it wishes to look through the EU shell entity as well.
• EU shell: will continue to be a resident for tax purposes in a Member State and fulfil relevant obligations as per national law, including by reporting the payment received; it may be able to provide evidence of the tax applied on the payment.
• Third country shareholder: while the third country shareholder jurisdiction is not compelled to apply any consequences, it may consider applying a treaty in force with the source jurisdiction in order to provide relief.

Scenario 3 Non-EU source jurisdiction of the payer – EU shell jurisdiction – EU-shareholder jurisdiction

In this case the source jurisdiction is not bound by ATAD 3, while the jurisdictions of the shell and the shareholder fall in scope.

• Third country source jurisdiction: this entity may apply domestic tax on the outbound payment or may decide to apply the treaty in effect with the EU shareholder jurisdiction.
• EU shell: this entity will continue to be resident for tax purposes in the respective Member State and will have to fulfil relevant obligations as per national law, including by reporting the payment received; it may be able to provide evidence of the tax applied on the payment.
• EU shareholder: this entity shall include the payment received by the shell undertaking in its taxable income, as per the national law and may be able to claim relief for any tax paid at source, in accordance with the applicable treaty with third country source jurisdiction. It will also take into account and deduct any tax paid by the shell.

Scenario 4 EU source jurisdiction of the payer – EU shell jurisdiction – third country shareholder jurisdiction

In this case only the source and the shell jurisdiction are bound by ATAD3 while the shareholder jurisdiction is not.

• EU subsidiary: this entity will tax the outbound payment according to the treaty in effect with the third country jurisdiction of the shareholder or in the absence of such a treaty in accordance with its national law.
• EU shell: will continue to be resident for tax purposes in a Member State and will have to fulfil relevant obligations as per national law, including by reporting the payment received; it may be able to provide evidence of the tax applied on the payment.
• Third country shareholder: while the third country jurisdiction of the shareholder is not compelled to apply any consequences, it may be asked to apply a tax treaty in force with the source Member State in order to provide relief.

Scenarios where shell entity’s are resident outside the EU fall outside the scope of ATAD3.

What to do?

First of all, monitoring the developments in the BEPS 2.0 and ATAD 3 proposals is advised. Also, looking at whether there are operating entities withing the group in low tax jurisdictions, entities with primarily passive income, and companies where the local substance may fall short on the types of criteria suggested by the EC. When the key risks are identified, choices may include removing problematic holding companies, using different jurisdictions, or taking steps to bolster local substance. International groups should take the appropriate measures in time to get ahead of these changes.

Do you have questions regarding the implications of ATAD 3 for your company or do you need certainty in advance? Feel free to call us! This is really dynamic work, which also gives you insight into your compliance with the changing international rules. We are happy to help.