EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients.
Recent Searches
In today’s landscape of international taxation, the concept of “substance” — the genuine economic presence and activity of a business entity in a jurisdiction — has become a focal point for scrutiny by local tax authorities, particularly in the context of the European Union’s ongoing efforts to combat tax avoidance. As jurisdictions tighten their rules against “shell entities” — business structures that exist primarily on paper with little to no real economic activity or substance — taxpayers face increasing pressure to demonstrate genuine economic presence. As we navigate these challenges, it is crucial for taxpayers to understand the implications of substance on their tax positions and to take proactive steps to ensure compliance and mitigate risks.
Unshell me not?
The European Union’s (EU) draft Anti-Tax Avoidance Directive 3 (ATAD 3), commonly referred as the “Unshell Directive,” represents the effort to curb abusive tax practices by targeting shell entities that lack economic substance within the EU. Originally scheduled for implementation in January 2024, this Directive seeks to ensure that tax benefits are granted only to entities engaged in real economic activities. It was intended to fundamentally reshape the landscape for Multinational Enterprises (MNEs) by establishing minimum substance requirements. It imposes on certain companies considered “at-risk” to demonstrate their substance through the three following indicators: having premises available for its exclusive use, having an active bank account in the EU and having a substance factor, i.e., either local resident director or local employees. The implementation is currently on hold due to a lack of consent between the EU Member States.
Does it mean that taxpayers can rest assured that their substance and local activities would remain unexamined?
On the contrary. Even absent a consent on a common set of rules, each Member State may – and for some actively do – still scrutinize and challenge taxpayers on their substance under their domestic legislation. For instance, the German legislator implemented a strict requirement into domestic legislation that mandates proof of active ‘management of the participation’ in a cross-border context. Absent such proof, (withholding tax) exemptions will be denied.
Germany
“Withholding tax reductions will be denied if a company with insufficient business substance is situated between the (indirect) shareholder and the domestic income-paying company. Germany requires an activity test for foreign shareholders to qualify for withholding tax relief, demonstrating a significant economic connection beyond mere asset management. Due to a lack of detailed guidance, the German tax authorities have created a questionnaire based on ATAD 3 criteria, such as the number of employees and business premises. However, the weighting of these criteria and whether they must be met cumulatively remains unclear. Recent regional tax court rulings have examined the application of these rules concerning active versus passive holding activities and the main (non-tax) benefit test.“
Jan-Rainer Hinz
EY Germany Partner, International Tax and Transaction Services (ITTS)
Poland, Belgium, the Netherlands, France, and Spain are jurisdictions where authorities are actively scrutinizing the substance of shareholders, underscoring the critical need for taxpayers to ensure compliance with local regulations.
Demonstrating beneficial ownership and countering abuse
The concern with respect to (lack of) substance is already on the tax agenda for quite a while. In 2019, the Court of Justice of the European Union (CJEU) issued their joint judgements in the so-called Danish cases, that all had one thing in common: Who should be considered as the beneficiary of the dividends or interest payments made?
The Danish cases share background that may be familiar to many taxpayers – local companies were all directly owned by parent companies located in the EU, which in turn were held by third-countries investors. The Danish tax authorities denied exemption of dividend and interest payments to EU-parents on the grounds that the direct EU shareholders were not beneficial owners of the payments received.
Many assume they meet the necessary standards, but the reality is that demonstrating compliance can be far more complex than anticipated.
Following the prejudicial questions by the Danish Court, the CJEU offered guidance on the application of the EU Interest & Royalty Directive (pertaining to interest payments) and the Parent-Subsidiary Directive (related to dividends), that was intended to assist national courts in evaluating domestic cases. While the EU Interest & Royalty Directive includes specific requirements concerning the beneficial owner, it lacks a formal definition that can be relied upon. Therefore, the CJEU referred to the concept outlined in the OECD Model Tax Convention. Through its case law, the CJEU refined the notion of the beneficial owner, as contained in the Directive, and confirmed that the withholding tax exemptions provided under the aforementioned Directives should be denied in case of abusive or fraudulent practices.
In cases where the recipient should not be considered the beneficial owner of payments, withholding tax exemption would be denied with, in worst-case scenario, an uncreditable source taxation since the “real” beneficial owner is located in another jurisdiction that does not have any relief in place.
Italy
"Foreign investors must carefully assess their investment structures to minimize the risk of challenges, particularly given the ambiguous definition of beneficial ownership in Italian law and the lack of clear guidelines on substance requirements for foreign holding companies. Recent trends from the Supreme Court indicate that a foreign company must meet three cumulative tests to qualify as a beneficial owner: (i) the ‘substantive business activity test’ to ensure the company is not artificially established; (ii) the ‘dominion test’ to confirm that the company can freely use its income without obligations to others; and (iii) the ‘business purpose test’ to determine if the holding company’s existence is justified by economic reasons beyond tax savings."
Simone De Giovanni
EY Italy Partner, International Tax and Transaction Services (ITTS)
And what has substance to do with all of this?
A lot! The CJEU explained that a lack of substance may be an indication of abuse, and benefits have to be denied – even in absence of any specific anti avoidance legislation in domestic law. However, the CJEU in their established jurisprudence, also emphasizes that a taxpayer needs to have appropriate, but not excessive, substance in line with their activities. Meaning, that a holding or financing company might not require significant substance in order to properly conduct its activities.
And while substance is not equivalent with having a beneficial owner status, not having an adequate level of substance would most likely forfeit taxpayer’s chances to demonstrate that standing.
"As an integral part of our team, I believe that every element plays a crucial role in our collective success, ensuring we maintain proper documentation and demonstrate substance to effectively support our clients in navigating the complexities of international tax. With EY’s extensive global network of offices (+700 offices in 150 countries),
We can be a trusted partner in this process, providing the expertise and resources needed to address the challenges of international taxation across multiple jurisdictions."
Tom Lambot
EY Luxembourg Assistant, International Tax and Transaction Services (ITTS)
So, what does it mean to “have substance”?
In Luxembourg, there is no definition embedded in the law. Some guidance on what is deemed essential for companies carrying out certain intra-group financing activities can be found in Circulaire L.I.R. n° 56/1 – 56bis/1 of 27 December 2016.
A Luxembourg taxpayer must be able to conduct its activities and manage the risk and for this, it must have real presence. In a nutshell, those requirements can be divided into three categories: (i) Day-to-day management, (ii) composition of the Board of Managers / Directors and (iii) execution of shareholder meetings.
Day-to-day management should be performed by qualified staff members in Luxembourg, including all administrative tasks, management of bank accounts, tax and legal compliance etc. Furthermore, it is usually expected that most of the managers live in Luxembourg or derive most of their professional income out of Luxembourg. Board meetings should be physically held in Luxembourg and each time a strategic decision is to be taken. Ordinary and extraordinary shareholders’ meetings should also be held physically in Luxembourg, at least once a year. Be mindful that any of those statements need to be supported with a real-life evidence.
"As jurisdictions tighten their rules, taxpayers must proactively demonstrate substance to navigate the evolving regulatory landscape and mitigate risks. Think of it like building a house: without a solid foundation, even the fanciest décor won’t keep it standing. We need to ensure our clients have that strong base of genuine economic presence to weather any regulatory storm!"
Gijs Voppen
EY Luxembourg Manager, International Tax and Transaction Services (ITTS)
The question remains: how can a taxpayer be assured that they possess sufficient substance in Luxembourg from a foreign perspective?
Based on our experience, other EU Member States typically take a keen interest in examining and scrutinizing dividend or interest payments made to their shareholders.
Every cross-border investment should be examined to ensure that the Luxembourg company meets the substance requirements of the other country.
Are you able to provide evidence of day-to-day activities conducted from a few years ago?
Where to start? As mentioned above, it is important to have qualified employees in accordance with the level of activity of the company and the risks and functions assumed working in an adequate office space of the company. Furthermore, skilled and experienced managers that physically meet on a regular basis to discuss and decide on investments, add-ons or re(financing) and corporate documents with respect to the business activity maintained in Luxembourg, are for sure key elements that should be considered.
Many would believe they all have this in theory. but in practice, it is not always easy to demonstrate. In the end, it remains a case-by-case analysis on the facts and circumstances at stake and the judgement of the (foreign) tax authorities or courts. Besides, challenges may come years later – are you able to produce evidence of day-to-day activities conducted in 2020, 2021 or 2022 for example? – Scrutiny and tax audits of (foreign) tax authorities have increased significantly over the last decade. So, it is now time to take your substance more seriously than ever.
"With over 10 years at EY, I am proud to be part of our dynamic global team, committed to helping taxpayers proactively improve substance, empowering them to navigate the ever-evolving regulatory landscape across jurisdictions and effectively mitigate risks."
Iga Mlynarczyk
EY Luxembourg Partner, International Tax and Transaction Services (ITTS)
Moving forward
Now is the critical time to minimize the risk of any challenges to your substance. With the international tax landscape becoming more intricate by the day, the need for proactive action has never been more urgent. By partnering with your local advisors to solidify your substance and prepare a robust defense strategy, you position yourself ahead of potential scrutiny. Take charge now to stay one step ahead – EY is here to help you navigate and protect your business with confidence.
This article was created in collaboration with EY entities.
Summary
In the current global taxation landscape, the idea of "substance", the actual economic presence of a business in a jurisdiction, is under increased scrutiny from local tax authorities, particularly due to the EU's efforts to combat tax avoidance. As jurisdictions tighten rules against "shell entities" that lack real economic activity, taxpayers must demonstrate genuine economic presence. It's vital for taxpayers to understand the impact of substance on their tax positions and take proactive steps to ensure compliance and minimize risks.
Related articles
The global tax landscape is in flux with the OECD's release of the Pillar Two Model Rules and their ongoing adoption worldwide. These rules aim to ensure that multinational enterprises (MNEs) pay at least a 15% tax rate in each of the jurisdictions where they operate, targeting base erosion and profit shifting. As per the Model Rules, if the effective tax rate (ETR) in a particular jurisdiction is below 15%, the so-called “top-up tax” will be levied. However, entities within an MNE group may face a situation where, due to a combination of how the jurisdictional ETR is determined and how charging provisions are applied, tax liabilities under Pillar Two potentially bear taxes that economically should be attributed to other entities or shareholders in cases of partial ownership.
Essential tax insights: Key takeaways from EY Luxembourg's Asset Servicers Roundtable
On November 14, 2024, EY Luxembourg hosted the Asset Servicers Tax Roundtable, a pivotal event that brought together tax experts and industry leaders to discuss pressing tax issues, regulatory updates, compliance challenges, and emerging trends. The purpose of this event was to address, in real-time, the challenges that this sector may encounter and to help participants stay continuously updated.