Anti Shell Directive – The EU cracks down on letterbox companies

On 22 December 2021, the EU Commission published a proposal for a new regulation “to determine rules to prevent the misuse of letterbox companies for harmful tax purposes”. This regulation defines the substance requirements for companies within the EU. These must be fulfilled in order to be recognized as a tax resident in an EU country.

What is it about?

Shell companies are often used in practice to achieve tax advantages without any economic motives for these companies. With the proposal presented on 22 December 2021, the EU Commission wants to ensure that companies based in the EU with low personnel and functional substance, i.e. letterbox companies, are identified and can no longer be used for tax optimisation. The proposal specifies the substance criteria that must be met by a company in order not to be considered a letterbox company, i.e. to be recognized as a tax resident in an EU country.

Who does the new regulation affect?

For the time being, only companies (regardless of their legal form) based in the EU are affected by the regulation. However, the EU Commission will present a proposal for the treatment of letterbox companies based outside the EU as early as this year. The Regulation does not provide for minimum criteria; the only exceptions are certain types of companies, in particular (i) certain regulated financial undertakings (e.B funds), (ii) companies with transferable securities listed on a regulated market (iii) and companies employing at least five full-time employees who take care of obtaining the relevant income (see below) and (iv) companies with holding activities which have their registered office in the same Member State as its member state. Shareholders or as the ultimate parent entity (UPE).

When does the regulation apply?

The regulation is due to enter into force on 1 January 2024. However, the question of whether a company is a letterbox company is based on the substance present in the country of residence in 2022 and 2023. We therefore recommend that companies with their registered office or group companies in the EU comply with the criteria of the new regulation as early as 2022.

How is it checked whether a company is a letterbox company?

The test is carried out in a two-stage test. In a first step, it is checked whether the company fulfils three aspects, so-called gateways (gateway test). In simple terms, the gateways are the following:

1. More than 75% of the company’s income comes from so-called relevant income. Relevant income includes income from passive income (interest, dividends, royalty income, income from the sale of securities, etc.) or income from immovable property or income from other movable assets (excluding cash, shares or securities) with a book value of more than one million euros held for private purposes; and
2. At least 60 % of the relevant income comes from cross-border activities or at least 60 % of the assets are invested in real estate or property, plant and equipment outside the Member State in which the registered office is situated; and
3. Day-to-day business and decision-making on material issues shall be outsourced to third parties.

If all three points are met, there is a rebuttable presumption that the company is a company with no substance (letterbox company). In this case, the company concerned must in principle prove its substance annually as part of the submission of the tax return. The presumption that it is a letterbox company is refuted if the company meets the following three substance criteria cumulatively:

1. The company has its own offices in the state of its registered office or has premises available for exclusive use; and
2. The company has at least one active bank account in the EU; and
3. The company fulfils at least one of the following two conditions (including subconditions):
4. At least one of the directors of the company

• Is resident or lives near the registered office of the company (commuting distance); and
• Is qualified and authorized to make the essential business decisions; and
• Makes active, independent and regular use of this power; and
• Is not an employee of an independent third-party company and does not perform the function of director or similar function with an independent third-party company.

1. The majority of the employees of the company are resident in the country of residence or live within commuting distance of the registered office of the company and are qualified to carry out the activities to generate the relevant income.

If the aforementioned substance criteria are not met, the company is generally classified as a letterbox company. However, the Directive explicitly provides for the possibility of counter-notification. In doing so, the company must be able to prove in a specific individual case that it pursues an economic (non-tax) purpose that does not require its own offices, its own bank accounts or its own directors, for example. It can also be asserted in the context of a counter-notification that no tax advantage results from the intermediary of the company. The EU member state must then check whether it wants to maintain its qualification as a letterbox company despite a counter-notification. Due to the substance criteria clearly stated in the directive, we assume that a successful counter-notification will only be possible in very few and specific cases.

What are the consequences of being classified as a letterbox company?

The taxation of the company in the state in which the company has its registered office itself remains unchanged. However, if a company is classified as a letterbox company, the country of residence is obliged either not to issue a certificate of residence or to provide this certificate of residence with a warning. As a result, the tax exemptions provided for in the double taxation agreements (DTAs) or in the EU agreements, such as the Parent-Subsidiary Directive, are no longer granted by the other EU member states. In particular, this means that these member states will no longer grant relief from withholding tax on dividend, interest or royalty payments to the letterbox company. In addition, if the owners of the company are resident in an EU member state, this country of residence will invest the relevant income of the company in accordance with the national tax law as if the income had flowed directly to the owners. Any taxes already paid in the country in which the company has its registered office are taken into account and DTAs between the source state and the country of residence of the (EU) holders are also to remain applicable in accordance with the guidelines. If the holders are resident in a third country, for example in Switzerland, there is no direct taxation on the income of the holders, since the directive is not applied by the third countries. Taxation in third countries will therefore in principle only take place when the actual distribution to the holders takes place. In our opinion, however, it is highly unlikely that they will then be able to reclaim the taxes paid in the state of the letterbox company as well as the taxes paid in the source state or have them credited.

In addition, Member States may provide for fines of at least 5% of the annual turnover of companies if they do not comply with the provisions of the Directive. The data on the companies with low substance, i.e. letterbox companies and those for which there is a presumption of missing substance due to the gateway test, will be exchanged among the EU states.

What does this mean for companies based in Switzerland?

Companies based outside the EU are not directly affected by the regulation. However, it can be assumed that the EU will already adopt a regulation this year that covers third countries. We assume that the substance criteria mentioned in the regulation will also be applied by the EU states in relation to Switzerland in the future. The DTAs of Switzerland with other states provide for the residence of a company in the state in which the company has its (statutory) registered office or its management. If these places fall apart, the company is generally considered to be located where the place of the actual management of the company is located. Companies based in Switzerland that do not meet the gateway test of the new regulation must be prepared for the fact that their residence could be questioned by EU member states if these EU member states have financial information about the company available or if they will one day receive corresponding reports.

What measures must now be taken?

We recommend that individuals and groups of companies review their structures to ensure that all companies they hold, in particular foreign holding companies or foreign intellectual property collecting societies, meet the required substance criteria. If it turns out that companies have a lack of substance, it must be decided whether these companies are to be provided with additional substance or whether the functions of these companies can be transferred to other companies with sufficient substance. Since the year 2022 is already included in the assessment, the analysis of the shareholding structure must begin as quickly as possible.

Result

The EU is fighting the letterbox companies which exist solely for the purpose of saving taxes. The EU regulation, which will come into force on 1 January 2024, defines the substance criteria relatively concretely, so that companies already receive legal clarity as to whether or not they will be considered a letterbox company. Since the criteria for determining the substance are based on the period 2022 and 2023, we recommend that companies with their registered office or group companies in the EU observe the criteria of the new regulation as early as this year. Since we assume that the substance criteria mentioned in the EU Regulation will also be applied by the EU states in relation to Switzerland in the future, we also recommend that local companies be in line with the substance criteria and, if necessary, take the appropriate measures. We are happy to assist you in reviewing your tax situation and in implementing a possible restructuring.

By Adrian Briner, Vischer, Switzerland, a Transatlantic Law International Affiliated Firm.

For further information or for any assistance please contact switzerland@transatlanticlaw.com

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