In 2021 the EU tackled business taxation with the aim of promoting a robust and efficient business tax system with long term benefits. However, while these amendments do push for better tax-evasion detection and ensure fair taxation, the existence of legal entities with no minimal substance and economic activity (Shell Entities) continues to lead to improper tax practices. Due to this, the European Commission is proposing a new Directive with the specific intent of dealing with the misuse of shell entities.

The Directive aims to tackle cross-border tax avoidance/evasion practices by creating one legal framework. In particular, this Directive will lay down tests to help Member States identify the shell entities which are created for misuse of tax purposes. It further introduces tax consequences to such shell entities and the automatic exchange of information between Member States.

Gateway Tests

The Directive proposes the following three Gateway Tests:

  1. mobile or passive income – more than 75% of the entity’s income is from passive income sources, for example, interest, royalties, dividends, leasing, and real estate;
  2. cross-border activity – more than 60% of its assets are located outside of the Member State or at least 60% of its income is earned or paid out from cross-border transactions; and
  3. outsourcing – day-to-day administration and decision-making on significant functions is outsourced.

If an entity resident in an EU Member State satisfies all three Gateway Tests, it will be required to report the matter to its tax authority. At this stage it will be required to explain whether it meets the minimum substance requirements.

Minimum Substance Requirements

Reporting on substance means “providing specific information, normally already arising from the undertaking’s tax return, in a way that facilitates the assessment of the activity performed by the undertaking” with specific focus on circumstances normally present in undertakings performing substantial economic activity.

The three elements deemed important are whether the entity:

  1. Owns or has premises available for its exclusive use in its Member State
  2. Holds at least one active bank account in the Union
  3. Has at least one director that is tax resident in the same Member State and dedicated to his activity (i.e. being appropriately qualified to hold such post), or a sufficient number of employees engaged in its core income generating activities who are tax resident in the same Member State.

The minimum substance report must be accompanied with a satisfactory level of documentary evidence and must be attached to the entity’s tax return.

The report is subsequently examined by the relevant authority. Undertakings which are a risk case (i.e. they passed the Gateway Tests) and whose reporting leads to a lack of at least one relevant element on substance, are presumed to be a shell entity lacking substance and being misused for tax purposes.

As a general rule, where an entity qualifies as a risk case but satisfies the minimum substance requirements, it is not deemed to be a shell entity for the purposes of the Directive. However, this presumption does not stop tax administration from stating that an undertaking is a shell due to improper evidence produced, due to domestic rules or if the undertaking is not the beneficial owner of any stream of income paid to it.

Following the examination of the report, undertakings that are deemed to be a shell entity are granted the right to dispute their presumed shell status by providing evidence portraying the activities and how they are performed, the reasons for setting up and maintaining the undertaking, and any resources used in its activities. If successful, the validity of the rebuttal is valid for 6 tax years, provided that the legal and factual circumstances do not change.


If an undertaking is deemed to be a shell entity, tax consequences proportionate to its tax impact are imposed. These consequences are three-fold:

  1. Any tax benefits provided by the Parent-Subsidiary Directive, or the Interest and Royalties Directive and applicable bilateral tax treaties are denied;
  2. New taxing rights over the income are provided to the shell entity’s shareholders (deducting any tax paid by the shell entity and assuming both entities are resident in an EU Member State), effectively introducing a new CFC-style charge; and
  3. Requests for a tax residence certificate will be denied or issued with a warning to prevent claiming double tax relief in another jurisdiction.


The Directive also introduces the possibility to request an exemption from the obligations of this Directive for undertakings which, although they pass the Gateway Tests and/or do not fulfil the Minimum Substance Requirements, are however used for genuine business activities without creating any tax benefits for themselves, the group of companies, or the ultimate beneficial owner.

The undertaking must “produce elements allowing to compare the tax liability of the structure or the group to which it is part with and without its interposition”. If the Member State is satisfied that this undertaking does not fall under the definition of ‘shell’, it shall be deemed as valid for 6 tax years provided that the circumstances do not change. After this period, the undertaking must repeat the process of requesting a new exemption.

Other exempt entities include listed companies, regulated financial undertakings, domestic holding entities and entities that have at least 5 full-time employees exclusively carrying out income-generating activities.

The Directive will also lead to automatic access of information on EU shell entities through the use of a central directory. Penalties for violating the reporting obligations are to be determined by the Member States themselves, with a minimum of at least 5% administrative pecuniary sanction of the undertaking’s turnover.

The EU Commission’s aim is for the Directive to come into force on 1 January 2024, provided it is unanimously adopted by all Member States.

This article was written by Dr Cherise Abela Grech and Legal Trainee Ms Jodie Arpa.

For more information, please contact Dr Ian Gauci or Dr Cherise Abela Grech.

Disclaimer: This article is not intended to impart legal advice and readers are asked to seek verification of statements made before acting on them.

Disclaimer This article is not intended to impart legal advice and readers are asked to seek verification of statements made before acting on them.
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