On 22 December, the European Commission presented its further proposals against tax fraud. These are:

1. a draft directive to lay down rules to prevent the misuse of “shell” entities for tax purposes,
2. a draft directive to ensure a global minimum level of taxation of multinational groups in the EU.

“Shell” entities

The purpose of this proposal is to prevent entities based in the European Union with minimal or no economic activity (shell entities) from being able to obtain tax benefits under international treaties or other EU directives. The draft directive is broad in scope and aims to affect all legal entities that can be considered residents of an EU member state for tax purposes, regardless of their legal form. This means that the directive should also apply to partnerships such as general partnerships and limited partnerships.
In practice, if an entity meets all of the following criteria, it should be subject to a new reporting obligation to the tax authority. These criteria are:

1. More than 75% of the income for the last 2 taxable years is considered passive income. Passive income includes interest, dividends, royalties, income from financial lease, income from immovable and movable property, income from financial activities, etc.
2. Significant cross-border element in the form of assets or income. In this case, a cross-border element is understood to mean that more than 60 % of the accounting value of the immovable and movable property was located outside the member state of tax residence of the entity in the previous two tax years, or that at least 60 % of passive income of the entity is earned or paid through cross-border transactions.
3. The in-house management of the entity and the administration of the entity have been outsourced.

Therefore, if the entity meets all of the above criteria, it will report to the tax authorities in its tax return whether it meets the prescribed minimum economic activity indicators (also referred to as “substance indicators”) such as having its own premises in a given EU member state, having at least one active bank account in the EU, or having management staff requirements. These minimum substance indicators will also have to be documented by the entity as part of its tax return.

If an entity fails to meet any of the above-mentioned indicators, it will be considered an entity with no minimum substance, i.e. a shell entity. At the same time, the respective tax authority will refuse to issue a tax domicile certificate to such an entity or will state that it is a shell entity. As a result, the entity will not have access to the tax reliefs and benefits arising from the double taxation treaties of the relevant EU member state or the relevant EU directives.

In addition, payments to third countries will not be treated as paid by the shell entity, but will be subject to withholding tax at the level of the entity that paid the shell entity. Incoming payments, on the contrary, will be taxed in the state of tax residence of the shareholder of the shell company. 

However, according to the proposal, it should be possible for an entity to prove the contrary by providing evidence such as detailed information on the business establishment, and not only for the purpose of obtaining tax advantages, employee profiles and the fact that decision-making about the company takes place in the member state of tax residence of the company. At the same time, this should not apply to, for example, companies with publicly traded securities or regulated financial entities.

Under the draft directive, it is proposed that EU member states enact a minimum penalty of 5% of an entity's turnover for failure to comply with its obligations under the directive.

The draft directive will now be discussed in the EU Council and member states must unanimously agree on this draft directive, which (if agreed in the EU Council) is expected to be transposed into national law by 30 June 2023 with effect from 1 January 2024.

Minimum level of taxation

This proposal sets out a way to calculate the effective tax rate in the individual jurisdictions and contains rules to ensure that large groups of companies in the EU pay at least 15% in income tax for each jurisdiction, in which they operate. The draft directive is issued in line with the OECD/G20 agreement on Pillar Two, which is intended to set a minimum level of taxation on the profits of multinational companies.

The proposed rules should apply to any large group, i.e. even a purely national group, and not only to a multinational group operating in the EU, including the financial sector, with total consolidated revenues exceeding EUR 750m per year. Conversely, they will not apply to government entities, international or non-profit organisations, pension funds or investment funds that are parent entities of a multinational group. 

The effective tax rate should be determined by the ratio of the total tax expenditure of the entity to its taxable income. If the effective tax rate for entities in the relevant jurisdiction is below the 15% minimum, then the Group must pay an amount of tax (top-up tax) to bring its effective tax rate to 15%. In the draft Directive, this is referred to as the so-called Income Inclusion Rule (hereinafter also “IRR”). This additional tax is paid regardless of whether the subsidiary is located in a country that has signed the OECD/G20 international agreement or not. The calculation of the effective tax rate shall be performed by the ultimate parent entity of the group, unless another entity within the group is delegated.

If the ultimate parent entity of the group is based outside the EU, where the minimum tax rate will not apply, the relevant EU member state, in which the group entity is tax resident, will apply the so-called “Under-Taxed Payment Rule”. This is a supporting rule to the primary IRR rule. This means that an EU member state should collect part of the top-up tax payable at the level of the entire group, if some jurisdictions, where group entities are located, tax below the minimum level and do not pay the top-up tax. The amount of the top-up tax that an EU member state will levy on group entities in its territory is determined by a formula based on employees and assets.

There are exceptions to the above rules. One of the exceptions is the de minimis exception. This means that if revenues are less than EUR 10m and profits are less than EUR 1m, then the IRR rule will not apply to group profits earned in that jurisdiction, even if the effective tax rate is less than 15%.

In addition, entities will be able to exclude an amount reaching a minimum of 5% of the value of tangible assets and 5% of wage costs from the top-up tax. This rule is called “carve-out”. At the same time, there should be a transitional rule for this exemption, namely that for the first 10 years the carve-out rule will start at 8 % of the book value of tangible assets and 10 % of wage costs. For tangible assets, the rate will decrease by 0.2% annually for the first five years and by 0.4% for the remaining years. For wages, the rate will be reduced by 0.2% annually for the first five years and by 0.8% for the remaining five years.

This exemption has been included in the draft directive in order not to restrict investments by multinational companies in a particular jurisdiction. At the same time, intangible assets are not included in this exemption because, according to the European Commission, income related to intangible assets is more susceptible to tax planning.

The draft directive also excludes from its scope income derived from international transport, as this particular sector is subject to specific tax rules.

The draft directive will now be discussed in the EU Council and member states need to agree on this draft directive unanimously.

It is envisaged that this Directive (if agreed in the EU Council) should be transposed into national law by 31 December 2022 at the latest, with effect from 1 January 2023.