The EU puts an end to Virtual Companies

It is well known the practice of many taxpayers, natural and legal persons, to establish virtual companies (i.e. companies without physical presence and real economic activity) in countries with preferential tax status such as Cyprus, Bulgaria, Ireland, etc., in order to avoid the paying taxes in the country where the income actually arises.

The European Commission presented in December 2021 a proposal for a directive to combat the abuse of these financial entities for unfair tax purposes. With this proposal, it is sought that entities in the EU, which have zero or minimal economic activity (shell entities), do not benefit from tax advantages, in order to ensure fair and efficient taxation and to prevent unfair competition.

The proposed directive wants some objective indicators of existence that help the national tax authorities of the member states to identify companies that exist only on paper. Shell companies identified in this way will be subject to new tax reporting obligations and will no longer be able to benefit from several tax advantages.

Specifically, the proposed provisions concern all businesses and legal entities that are considered tax residents of an EU member state and that can obtain a certificate of tax residence from that state. Excluded are listed companies, supervised financial companies, holding companies whose beneficial owners, as well as the commercial companies in which they participate, are residents of the same member state, companies that employ at least five employees exclusively in the activity that generates their income etc.

The minimum substance test

Entities that meet all of the following criteria should provide further information regarding their status:

1. Companies whose 75% of income in the previous two years is included in so-called passive income, as further specified (e.g. dividends, interest, royalties, income from real estate, banking and financial activities, financial leases, services provided by affiliated companies etc.

2. Companies that have mainly cross-border activities.

3. Companies that outsource their day-to-day management and decision-making on important operations.

The above companies must declare annually in their tax return if they meet the following minimum status indicators:

To have exclusively their own facilities-offices, -Their own active bank account within the EU and at least one manager, -Tax resident in the same member state, who has the necessary qualifications and deals exclusively with the company’s activities, -Has power of representation, etc. or if the majority of employees employed in the activity that generates the company’s income are tax residents of the member state, etc.

It is worth noting that a company, even if it is deemed to have no existence, can be exempted from the application of the directive if it proves and is officially accepted by the Tax authorities that it was established for genuine commercial reasons and without the intention of tax evasion and avoidance. If a company is deemed to be virtual, it will not be able to obtain a certificate of tax residence from the Member State where it is established, it will not be entitled to the protection of bilateral double taxation treaties, it will not be entitled to the application of the Parent-Subsidiary Directive for the exemption from withholding tax on dividends and the corresponding instructions on rights and interest etc.

Member States’ tax authorities will automatically exchange information on shell companies established in their territory with other Member States. This information will include their Tax identification Number (TIN), their shareholders and ultimate beneficiaries, an indication of which other Member States the information may concern, etc. The Member States will determine the penalties for companies not complying with the directive, which proposes a minimum fine equal to 5% of their turnover. The directive should be adopted by the member states by June 30, 2023 and start to be implemented from January 1, 2024.

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