The “UNSHELL Directive” or ATAD 3 – What’s in store for the Luxembourg alternative investment fund industry?

The recent proposal for a new Directive1 (referred to as the Anti-Tax Avoidance 3 or “ATAD 3” as well as UNSHELL Directive – hereafter the draft Directive) marks the next step of the Commission’s vision to provide a fair and sustainable European business tax system and to support the economic recovery from the pandemic and adequate public revenues for Member States. So-called “shell” entities are targeted i.e., undertakings with no or minimal economic activity, used as instruments of tax evasion or tax avoidance. 

If an undertaking qualifies as a shell for tax purposes, access to double tax treaties or EU Directives will be disallowed. Transparency is further increased through an automatic exchange of information on any undertaking that is at risk to be a shell, which would enable Member States to request the Member State of the undertaking to conduct a tax audit.

The draft Directive is now being reviewed by Member States and could potentially be subject to further amendments. Ultimately, the ATAD 3 will have to be transposed into Member States’ national laws by 30 June 2023 for the rules to come into effect as of 1 January 2024.

The draft Directive will impact the alternative investment fund industry which often relies on intermediate companies to structure their investments. 

Approach and consequences of the draft Directive

The draft Directive lays down three “gateway” criteria which, if cumulatively met, will require an undertaking “at risk” to report. The criteria link to (i) relevant income, i.e. if more than 75% of the entity’s revenues of the last two years is passive income such as interest, dividends and income from the disposal of shares or income from immovable property (or in the absence of income where more than 75% of the total book value is represented by private equity / real estate investments); (ii) engagement in cross-border activities with a threshold of 60% of the book value of certain assets located or relevant income derived from abroad; and (iii) outsourcing of own administration, i.e. whether in the preceding two years, the entity outsourced the administration of day-to-day operations and the decision-making on significant functions to trust and company service providers.

Any entity “at risk” will be required to disclose and document its substance in its annual tax returns. More precisely, the entity must confirm that it has (i) its own premises or premises for its exclusive use, (ii) at least one active bank account of its own in the EU and (iii) one or more local, qualified, authorized and active directors who independently take decisions in relation to the relevant income or the majority of full-time qualified employees resident close to the entity. 

An entity “at risk” not meeting these three minimum substance criteria will then be deemed to be a shell company and face the tax consequences of the draft Directive: the Member State of residence of the shell entity will either not issue a certificate of tax residence to the shell company or provide such certificate but with a warning that it is not entitled to double tax treaties or EU Directives benefits.

Since a tax residency certificate is a key condition, the other Member States will therefore deny access to the benefits under tax treaties and EU Parent-Subsidiary and Interest/Royalty Directives to the shell company and disregard the shell company so as to tax its relevant income as if it had accrued directly to the shell company’s shareholder(s). It should be noted that the shell company will remain taxable in its Member State of establishment and thus will have to fulfill all relevant tax obligations, irrespective of any taxation of its relevant income in the Member State of tax residence of its shareholder(s) and/or the Member State of a company making payments to it. 

First-sight takeaway for the Luxembourg structures

Managers of alternative strategies (private equity, private debt, infrastructure and real estate) often structure their funds with an onshore (Luxembourg) platform in order to avail of the EU passport. In certain cases, others still set-up their fund offshore (US, Cayman, Jersey, etc.). A common denominator for all these funds is the use of investment companies (in Luxembourg) to hold such assets (for a number of commercial reasons, including access to Luxembourg’s network of double tax treaties and/or EU Directives benefits). 

Looking at the gateway tests, such holding companies will meet the relevant income and  the cross-border activities criteria. With respect to  the outsourcing of own administration and decision-making, the draft Directive does not elaborate much. However, the Preamble clearly refers to situations where an entity relies on professional third-party service providers or enters into agreements with associated enterprises for the supply of administration services in order to set up and maintain a legal and tax presence.  

There are Luxembourg investment companies that outsource their daily operations as well as their decision-making to trust companies and should therefore pass each of these gateways: they would then be considered at risk, which will trigger a reporting obligation via their tax returns. The information reported will be automatically exchanged with other EU Member States within 30 days from the filing of tax returns.

Undertakings which do not outsource the day-to-day administration, or the decision-making should, on the other hand, not be in the scope of ATAD 3 (“low-risk” entities).

In the same vein, the following entities passing the gateway tests should be carved-out: companies which have a transferable security admitted to trading or listed on a regulated market or multilateral trading facility, certain regulated financial undertakings, and companies with at least five own full-time equivalent employees or members of staff exclusively carrying out the activities generating the relevant income. 

While these exclusions should cover, among others, securitization companies which list their notes, companies established as Alternative Investment Funds (AIF) managed by an AIF Manager as well as entities covered by the EU 2017 Securitization Regulation 2017/2402, it remains to be seen what fate will tell for certain ad-hoc vehicles e.g., Investment Companies in Risk Capital (SICAR). Interestingly, the exemption may extend to a Luxembourg company that is held by another Luxembourg tax resident shareholder. 

Two possibilities of not being affected by the tax consequences of being qualified as a shell 

First off, an entity having crossed the gateway and therefore considered “at risk” and having to report can still demonstrate that its existence does not create any tax benefit for itself, the group of companies of which it is a member or for the ultimate beneficial owner(s). Concretely, this means that the entity must provide evidence to the tax administration of its place of tax residence that allows to compare the overall tax burden of the beneficial owner(s) or of the group as a whole, with and without the entity’s interposition. If the tax administration concludes that the evidence satisfactorily demonstrates the lack of tax motives, it can grant to the entity at stake an exemption that may be valid for a total maximum period of six years. Practically, for commingled funds, given the variety of investors, it may be difficult to secure such exemption.

Secondly, the draft Directive grants the right to an entity that is presumed to be a shell because it does not meet one or more of the indicators of minimum substance or because it does not provide satisfactory supporting documentary evidence, to rebut this presumption. For this, the entity must prove to the tax authorities of its country of residence that is has performed and continuously had control over, and borne the risk of, the business activities. The evidence produced is expected to include information on the commercial (non-tax) reasons for the establishment of the company, on the employees used to perform its activity and on the nexus with the Member State as regards the decision-making concerning the company’s activity.

There are numerous reasons why fund managers use intermediate holding companies: segregation of assets and risks, structuring for pledge, segmentation of activities by geographical areas, currency or other criteria, investor protection and access to leverage are some of the legal and commercial motives that justify relying on several layers of companies. As a result, it may be possible to rebut the presumption of being a shell.

Alternative asset managers are well-advised to already pay particular attention to the draft Directive and to carry out an initial impact assessment on their corporate structures, even if the draft Directive is planned to be effective only on 1 January 2024. Given that the gateway criteria refer to the preceding two tax years, the way of setting-up and operating holding companies as from tax year 2022 will already influence what impact the provisions of the draft Directive will finally have in 2024. 

As a final remark, while the ATAD 3 targets EU shells, it is interesting to note that the Commission made it clear that it will come up with another regulation to address non-EU shells in the course of 2022. As the UK is positioning its Asset Holding Company regime as from April 2022, it is expected that such companies should thus be subject to somewhat similar provisions as Luxembourg holding companies moving forward. tandfirst body