How the EU Commission is Cracking Down on Shell Companies

Shell companies are notoriously used for tax avoidance and evasion in transfer pricing, and if the EU’s new year’s resolution is to prevent this from happening, well, it’s off to a good start. On December 22, 2021, the EU Commission released a proposed directive—full of consequences—in hopes of eliminating such tax schemes.

The directive denies tax benefits (and in some cases, slaps on withholding taxes) to entities who are shell companies—and for the most egregious offenders, it also adds new reporting requirements. (Now do we have your attention?) Perhaps most importantly, though, the directive offers guidance on how tax authorities can detect companies that “exist merely on paper.”

What the Directive Outlines

How? The directive outlines three levels of indicators that suggest a company could be a shell, existing solely for tax purposes. If a company meets even one of those criteria, it’s flagged and denied certain tax benefits. If it’s flagged under all three criteria, then the company will be held to additional reporting requirements. So, what are these indicators?

• The first asks tax authorities to look at the last two years of a company’s income and see how much of it is passive. If it’s more than 75%, then the company will be called out.
• The second level of indicators determines if most of the entity’s assets are located outside the country or most of the transactions are cross-border. If more than 60% of the book value of the company’s assets are located outside the country or at least 60% of business transactions stem from transactions with other jurisdictions, then that’s a signal the company could be a shell.
• The third level of indicators looks at the company’s management and staff to see how much of the business is conducted in-house. If over the last two years, day-to-day operations were outsourced, then again, that’s a signal that something’s up.

Having just one indication is bad enough, but if a company meets all three criteria, then things get even worse. Companies will have to defend their economic substance in their tax returns, including, of course, supporting documentation. If a company wants to contest the determination, it can—and the directive outlines how, starting with establishing the commercial (non-tax) reasons for its existence and the decision-making that takes place at the entity.