12 Apr 2022

EU Directive on Shell Companies

What are shell companies? These are legitimate legal entities that do not own assets or conduct business operations.  Although they are not illegal, they may be used illicitly.  Shares of shell companies are not traded on stock exchanges.  Most exist on paper only and are little more than a mailing address. That is why the European Commission (“EC”) has issued a draft directive on shell companies.

Legal vs Illegal Use of Shell Companies  

Examples of the legal use of a shell corporation could be to serve as vehicles in cross-border transactions, such as mergers and acquisitions.

However, shell companies are sometimes used to conduct illegitimate activities.  An important feature of this type of company is the ability to disguise true ownership.  In this sense, money laundering is commonly associated with shell companies.  Shell companies are also a convenient vehicle to prevent income from illegal activities from being discovered.  In addition, high-income individuals often establish shell companies in different locations to disguise their earnings and evade taxes.

Hence, shell companies are used for a variety of reasons, some shell companies have a legal purpose, while others do not.  Shell companies play an important role in markets around the world, despite being potentially hazardous financial entities.

Directive of the European Commission on Shell Companies

The European Commission (“EC”) published a draft Directive, on December 22, 2021, aimed at controlling the use of corporate vehicles to obtain tax advantages within the EU (“Directive“).  The Directive is primarily aimed at shell companies established within the EU by non-EU investors.  The Commission plans to apply the Directive starting from January 1, 2024, with a two-year lookback.

Companies that fall under the Directive’s criteria will have to submit reports annually showing evidence about their substance to the EU Member State of residency. The Directive applies to EU resident entities, partnerships, or other entities without legal personality.

To establish whether a company will be presumed to be a “shell”, the substance indicators should be considered.  The substance indicators are as follows:

  • The first level of indicators looks at the activities of the entities based on the revenue they generate. If an entity generated more than 75% of its revenue in the previous two years from activities other than its trading activity or if more than 75% of its assets are in real estate or other private property of high value.
  • The second gateway requires a cross-border element. If the company generates the largest part of its revenues from transactions linked to a different jurisdiction or transfers this income to other companies abroad, the moves on to the next gateway.
  • The third gateway looks into whether the administration and management are outsourced or performed mostly within the business.

If an entity checks all three boxes, it will be required to include additional information in its tax return that indicates “substance”.  An entity is deemed to be a shell company if it fails at least one of the criteria.

Companies deemed shell entities will not be able to take advantage of tax benefits offered by their EU Member State residency.   The Member State may deny the shell company a tax residence certificate or the certificate will specify that the company is a shell.