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Freshfields Risk & Compliance

| 9 minutes read

Unshell – a proposed EU Directive to fight the (mis)use of shell entities

On 22 December 2021, the European Commission published a draft proposal for a directive to prevent the misuse of shell entities for tax purposes (the Unshell Directive). Recent investigations, such as OpenLux and, more recently, the Pandora papers have increased the political pressure on the EU to take action in this area and members of the European Parliament were particularly pivotal in pushing the Commission to act. Whilst there are other ongoing tax initiatives aimed at combating tax avoidance such as changes to the directive on administrative cooperation (DAC) and the anti-tax avoidance directive (ATAD), the Commission feels that specific measures are needed to tackle the perceived misuse of shell entities for tax evasion and tax avoidance purposes (which have been lumped together for these purposes). The proposals are broadly drafted and may lead to additional reporting and compliance obligations as well as the denial of tax treaty benefits and additional tax burdens in the alleged shell’s shareholder jurisdictions to the extent covered by the Unshell Directive. The proposals follow on from the public consultation on this topic which found the definition of shell entities across the EU lacked coherence and national tax authorities did not have enough information for them to be able to use the tools already at their disposal effectively.

Given the proposal’s aim of taking further steps to combat tax evasion and avoidance is obviously met with broad approval from relevant stakeholders, it appears likely that the Unshell Directive will be adopted in some form, despite the requirement for unanimity amongst the Member States. However, the concrete details and mechanics of the proposal are highly controversial and, to a certain extent, still unclear based on the current draft; therefore, changes to the proposed Unshell Directive in the course of the legislative process can be expected. The major concern stems from the fact that entities with only limited substance – in terms of scope of activities, number of employees, physical infrastructure etc – are not only or even pre-dominantly used for tax evasion or avoidance purposes. Special purpose vehicles such as, in particular, financial holding companies are generally accepted and frequently utilised, both in corporate groups as well as below fund structures, and may rely on both treaty benefits and tax exemptions provided for in the Parent Subsidiary Directive or the Interest and Royalties Directive. Such entities are characterised by the fact that their economic purpose and level of activities only require limited physical substance to begin with. While the Commission acknowledges that entities with limited substance are not per se a sign of tax evasion or avoidance, due to the breadth of the Commission’s proposal, such entities may also fall within its scope and will need to assess its potential impact now.

The Commission’s timeline for the proposal is very ambitious, aiming for adoption in the course of this year, with implementation in Member States by mid-2023 and domestic application from the beginning of 2024.

The Unshell Directive proposal provides for (i) specific criteria to identify “entities at risk” and shell entities, based on their business activities and substance, (ii) the exchange of relevant information between Member States and (iii) tax consequences for those having certain dealings with identified shell entities.

Identification of shell entities

The proposal provides for a multi-level test to determine, as a first step, whether an entity is ‘at risk’ of qualifying as a shell entity and, as a second step, whether it does in fact qualify as such. For now, the proposal is limited to potential shell entities resident within the European Union; however, a further proposal targeting shell entities in third countries could potentially follow at a later stage.

Step 1: Privileged Entities / Exclusions

There are a number of exclusions from the scope of the proposal. For instance, certain entities which are thought to be already subject to adequate levels of transparency, such as listed or regulated financial entities, are exempt and correspondingly not subject to the reporting obligations. The same applies to entities with at least five FTE employees exclusively carrying out activities generating relevant income. It may be worth noting that there are also certain exclusions applying to holding companies, which, however, require in each case that the entity’s beneficial owner, shareholder or ultimate parent entity is located in the same jurisdiction as the holding company; therefore, local top-level holding entities would not benefit from such exclusions.

Step 2: Gateways

If, based on a self-assessment, an entity passes through all of the following three gateways, it is considered to be “at risk” of qualifying as a shell entity and will have to comply with the reporting obligations outlined in Step 3 below.

  • Gateway 1 (geographically mobile entities):this looks at the sources of generated income and, to a certain extent, the assets owned by the entity; it is fulfilled if either:
    • more than 75 per cent of the revenue in the previous two tax years qualifies as “relevant” (i.e. passive) income such as income derived from financial assets, royalties, financial leasing, immovable property, certain assets held for private purposes as well as from other financial activities and even income from services outsourced to associated enterprises; or
    • more than 75 per cent of the book value of the entity’s assets are real estate property, shares or other certain assets held for private purposes, even if no income is derived therefrom during the two year-period.
  • Gateway 2 (cross border activities): this is fulfilled if more than 60 per cent of the entity’s relevant income is earned or paid out cross-border or if more than 60 per cent of its tangible assets within the preceding two tax years were located outside of the entity’s Member State.
  • Gateway 3 (outsourcing operations and decision-making): this gateway will be fulfilled if, during the preceding two tax years, the day-to-day operations and decision-making on significant functions has been outsourced. The precise application of these criteria is unclear, for instance as to what level of outsourcing would be deemed harmful and whether this would only apply to outsourcing to external service providers or whether outsourcing such activities to a group company would be captured as well. It would also be helpful to clarify the extent to which the relevant significant functions would vary depending on the nature of the respective entity and business in question.

Due to the two-year look-back period, and bearing in mind the Commission’s intention that the Unshell Directive will apply from 1 January 2024, this may mean a company’s current position could already be relevant to this analysis.

Step 3: Reporting and Presumption as Shell Entity

An entity which passes through these three gateways will be required to report on the following three ‘indicators’ of minimum substance for tax purposes in its annual tax return and will be required to provide documentary evidence. Any entity unable to tick all three boxes will be presumed to be a shell entity.

  • Premises: The entity has its own premises in the Member State or premises for its exclusive use. It is unclear whether each group entity located within the same jurisdiction would have to meet these requirements separately (which, in our view, would not be necessary to satisfy the policy intention behind the Unshell Directive).
  • Own bank account: The entity has at least one active bank account in the EU.
  • Directors/employees:The entity must have either of the following alternatives:
    • At least one director is resident in the relevant Member State or is a commuter (i.e. at a distance from such Member State that is compatible with properly performing directors’ duties). Such director must be properly qualified and independently authorised to take decisions on behalf of the entity and neither employed by or a director of other non-associated entities. Various aspects of this indicator are problematic and/or unclear, such as how the ‘commuter’ alternative would apply as well as the scope of associated groups, in particular in the context of fund holding structures. Also, given holding entities’ often limited activities, it seems as if the commuter alternative could be fulfilled even with managing directors not residing in the immediate proximity of the entity’s Member State, but clarification of this point would be helpful. In any event, it should be ensured in the legislative process that the Unshell Directive’s governance requirements do not impose burdens on taxpayers which go beyond what is needed for the entity’s proper operation considering its business purpose.
    • The majority of its FTEs are resident in the relevant Member States or commuters (see above), and such employees are qualified to carry out the entity’s income-generating activities.

Step 4: Rebuttal and Exemptions

The presumption of shell entity status that emerges from the steps outlined above can be rebutted by providing evidence of the business activities performed to generate the relevant income. Such evidence could include documentation to explain the commercial rationale behind the establishment of the entity, employee profiles as well as evidence that the decision-making in relation to the relevant activity was indeed performed in the relevant Member State.

Alternatively, entities within the scope of the Unshell Directive can apply for an exemption from their reporting obligations by providing evidence of the absence of a tax benefit for the beneficial owner(s) of the entity or the group. Member States are entitled to grant the exemption for a period of five years as long as the factual and legal conditions remain unchanged.

Whilst those entities that are able to rebut the presumption or successfully apply for an exemption will not be subject to the tax consequences of the proposed rules, they will still be subject to the respective reporting, documentation and procedural requirements imposed by the Unshell Directive.

Exchange of information

Member States will automatically exchange information on the entities ‘at risk’ irrespective of whether the entities are ultimately deemed to be shell entities or not. Such exchange includes information relating to the successful rebuttal of the presumption outlined above. In addition, tax audits can be requested by other Member States if they have reason to believe that the substance requirements are not met.

Tax consequences

 As mentioned, the Unshell Directive only applies if the (alleged) shell entity is resident in a Member State of the European Union. As such, it will be subject to ‘regular’ taxation in such Member State. However, one consequence of being classified as a shell entity is that the Member State would not issue a tax residence certificate or would only issue such certificate with a caveat that the entity is not entitled to treaty or relevant directive benefits as a result of its status as a shell entity.

To the extent that the shell entity’s shareholders reside in a Member State, there is also a treaty-override with the effect that such Member State should treat the shell as a “flow-through” entity and tax its income as if it had been directly accrued to its shareholder (similar to the position under CFC taxation regimes). Credit would be given for tax paid in the shell’s jurisdiction but no explicit statement is made as regards credit for foreign withholding tax that has been paid which is likely to be based on the provisions of the treaty with the jurisdiction of the source of the payment.

In addition, the jurisdiction of the source of the payment, if this is a Member State, would deny treaty or directive benefits in relation to the shell entity’s jurisdiction. However, it must apply a “look-through” approach and apply the tax treaty or relevant implemented directives in relation to the shareholder jurisdiction(s).


As mentioned above, in order for the Unshell Directive to become effective, the draft needs to be unanimously approved by Member States and subsequently transposed into domestic law. The provisions are intended to take effect as of 1 January 2024 and would need to be transposed by 30 June 2023 at the latest.

The Commission’s webpage on this proposal is available here with links to relevant materials. As per its usual procedure, the European Commission opened a feedback period for interested stakeholders on the proposed Unshell Directive, which runs until March 2022.

Negotiations on the Commission’s proposal are about to begin, under the leadership of France, which holds the Presidency of the Council for six months. Amendments are likely be made by the Member States and it remains to be seen what form the final Unshell Directive will take. In light of the Member States’ varied views on how shell entities should be defined and what level of substance should be required, these points are likely to be the subject of extended discussion. However, the Pandora papers scandal has given real impetus to these proposals and with mounting public pressure on governments to take further steps to tackle tax abuse, Member States seem to be agreed on the need for action in this area. It therefore seems highly likely that these proposals will come into effect, albeit the exact shape this will take is still to be decided. Entities potentially in scope, such as SPVs or financial holding entities, should monitor this process very closely and start assessing the potential implications and whether existing structures need to be reorganised now.