In December 2021, the European Commission published a proposal for a directive that sets out rules to prevent the abuse of entities without sufficient economic substance for tax purposes (the Unshell Directive). Entities that do not meet the minimum economic substance requirements will not be able to claim the tax benefits of double tax treaties and EU directives.
Notification obligation
Entities that meet the following three criteria will be considered at risk and will be required to report selected information about their economic substance in their tax return:
- more than 75% of the entity's total income for the last two tax years is passive income (dividends, interest, royalties, rent, etc.);
- revenues are generated mainly through cross-border transactions;
- administration and management have been outsourced in the last two tax periods.
In its tax return, the reporting entity will be required to report information regarding the following minimum economic substance requirements:
- has premises which it may use exclusively;
- has at least one active bank account in the EU;
- at least one member of the statutory body or a majority of the qualified employees are tax residents in the EU country.
The information will be the subject to an automatic exchange of information between EU countries. Failure to comply with the reporting obligation or providing false information will result in a financial penalty of up to 5% of the turnover for the tax year.
Consequences of failure to meet the minimum economic substance requirements
If the notifying entity does not meet the above minimum economic substance requirements, it has the opportunity to dispel doubts through other means of proof by demonstrating to the tax authorities actual economic activity or the absence of a tax advantage.
If the entity fails to meet the minimum economic substance requirements, and fails to disprove the doubts with further evidence, it will not be issued a certificate of tax residence for foreign purposes and will not be able to benefit from double taxation treaties and EU directives. As a result, payments of passive income (dividends, interest, royalties) from a Czech company to such a foreign EU entity could be subject to withholding tax at the rate of 15% under the Income Tax Act.
Current situation
In 2022, the European Parliament's Economic and Monetary Affairs Committee proposed several changes, including relaxing the requirement for in-house (non-outsourced) governance and management of the entity, reducing administrative burdens or penalties, and others.
The original proposal foresaw the directive coming into force on 1 January 2024 with retrospective effects to the previous two years (2022 and 2023).
Given the potential significant impacts on international structures, further changes to the draft directive or postponement of its effectiveness cannot be ruled out (currently, it is mentioned to postpone its effectiveness to 1 January 2025, with retrospective effects retained until 2023 and 2024). The draft directive and possible modifications should also be considered by the ECOFIN Council. The next ministerial meeting is scheduled for early December 2022.
Summary and recommendations
This directive may have significant negative tax implications for international structures. If you have an international structure, we recommend you check the tax implications of the draft directive.
As a result of this directive, as well as existing measures, the tax regime for entities without sufficient economic substance is gradually tightening. We expect that their use will not be possible or tax-efficient in the near future. In view of the possible retrospective effects of the directive until 2023 and 2024, we believe that now is the right time to review the set-up of international structures.