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The case for SPV exemptions in the EU's Unshell Directive

Luxembourg continues to attract cross-border alternative fund groups, thanks to a regulatory regime that facilitates the various structures used to hold, buy, sell and transfer assets around the world, along with its ecosystem of specialised service providers. The EU is keen to ensure that fund structures along with other corporate entities are properly accounted for and supervised to minimise the risk of their use in tax avoidance schemes.

The EU's planned third Anti-tax Avoidance Directive was first proposed by the European Commission in December 2021 specifically to prevent misuse of so-called shell companies – “letterbox companies”, as they are described in the German version of the draft directive. The 'Unshell Directive’, as ATAD3 has been dubbed, could potentially have significant implications for L3A members in the fund administration sector and their clients.

The scope of the draft directive covers all EU-domiciled entities that can obtain a tax residence certificate in its residence state, and may therefore also affect subsidiaries of alternative funds established in Luxembourg or elsewhere in the EU.

Under the directive, entities deemed to be shell companies – vehicles that do not meet a prescribed minimum substance test and are unable to rebut the presumption of shell company status – would be denied exemptions and advantages under double tax treaties, as well as the EU's Parent-Subsidiary Directive and Interest and Royalties Directive.

Carve-out for fund industry entities

There are carve-outs, mainly for the financial service industry covering directly or indirectly regulated funds such as UCITS and AIFs, as well as AIFMs and other management companies, other entities holding transferable securities that are listed on regulated markets, and domestic holding companies.

However, the absence of one vital carve-out could cause problems for funds, their managers and administrators: the directive does not provide for an exception for subsidiaries of investment funds that are frequently used for various legitimate reasons to acquire, manage and dispose of assets in a cross-border context.

We have already addressed many of the myths and misunderstandings about special-purpose vehicles before, as well as noting the many economic justifications for their use such as operational efficiency, potentially reduced financing costs, and risk mitigation characteristics for investors. Research conducted for L3A has highlighted their critical role in facilitating private equity investment in businesses, real estate and infrastructure projects across Europe.

As we pointed out in our submission to the European Commission in April 2022, the Unshell Directive in its present form focuses on substance in terms of employees, registered offices, bank accounts, and who makes decisions and where. The research we commissioned finds that they are legitimate entities that must be assessed on a case-by-case basis to understand their genuine economic substance and the commercial rationale of their existence.

Discussions may run and run

An argument has been made – with which we agree – that since SPVs are exempt already under pillar 2 of the EU Minimum Tax Directive instituting a minimum corporate tax rate of 15%, provided they are 95% or more owned by one or more AIFs or UCITS funds, a similar carve-out logically should be provided under ATAD3 as well.

There is no time to waste in verifying and updating information on client funds and their subsidiaries. However, the ambition of Sweden’s EU Council presidency to finalise the legislation by June in order to complete implementation by January 2024 is now set to slip since there is no consensus between member states on the details of the proposal.

Responsibility will now pass to the Spanish EU presidency that takes over in July, and a final decision could be delayed by a year or more. Entry into application earlier than January 2025 now looks unlikely, even if member states agree on a compromise text.

L3A would like to see changes to address specific concerns regarding subsidiaries of investment funds, with the proposed ATAD3 text amended to ensure that substance tests incorporate sensible provisions and ensure that directors can take on mandates across a broad but reasonable range of clients.

Our members already seek to ensure that the boards of Luxembourg companies operate to the highest standards of corporate governance; for example, with meetings being held within the country attended by all directors wherever possible. Moreover, directors must be able to demonstrate that the number of mandates they hold and the related workload are manageable in practice.

Upholding the outsourcing model

Similarly, outsourcing may be a concern for a sector for which third-party administration is a tried and tested model. If managers are required to take fund services functions back in-house, they will face problems in sourcing the professional staff they need with the required skills and expertise, which would cause instability in the market and increase the risk of late reporting or non-compliance with tax and regulatory obligations.

Companies deemed to have failed the minimum substance test should still have the possibility to rebut the presumption that they are shell entities. Given that all tax benefits obtained by a Luxembourg company may be challenged on grounds of existing anti-abuse legislation under foreign tax law or applicable tax treaties if the company lacks appropriate substance, substance requirements must be a key consideration of every tax analysis.

In a European context, EU law as interpreted by the European Court of Justice must be considered, establishing the wholly artificial arrangement doctrine that requires companies to have appropriate but not excessive substance for the activities performed. On this basis, it can be assumed that Luxembourg subsidiaries of investment funds should commonly be able to rebut the presumption of being a shell entity, despite not fulfilling one of the prescribed substance criteria – resident directors and board meetings within the country, employees and access of office facilities.

However, this would come at a cost in terms of analysis, reporting obligations in corporate tax returns, and the time required to monitor developments relating to ATAD3. Under these circumstances, while the legislation should not result in many companies being classified as shell entities, the related compliance costs would overall be significant, reducing the returns of investors such as pension funds and life insurers – and undermining the ambition of many European countries to encourage individuals to undertake their own retirement provision.

No time to waste

We will have to wait to see how the current progress of the legislation develops over the coming months. But there are important steps that administrators and their clients can take while waiting for the rules to be finalised.

They should review governance models to ensure appropriate levels of substance are in place in Luxembourg - which should generally be a case of fine-tuning. And they might also consider documenting the role the corporate entity plays in the overall structure, with particular focus on its legitimate business purpose.


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