Corporate Substance - time to get it right

By Gareth Hughes and John Holt

In most transactions, value comes to be realised when a company is sold and in certain cases (e.g. private equity), proceeds distributed to investors. Frequently, it is expected that a combination of local tax exemptions and double tax treaties will eliminate tax on gains and distributing the proceeds to investors. However, the landscape is changing radically and groups not moving with the times could face a real erosion of value.

Corporate substance to support tax treaty claims has long been talked about. We explain why tax authorities see this as important, even though it is not a feature of tax treaties, and how the EU ATAD 3 directive will test substance and cause issues for entities lacking it.

In recent years, tax authorities have been tackling the use of abusive and aggressive tax structures by companies operating across borders. As a result, there has been an increasing focus on companies having ‘substance’ from a tax treaty perspective. This is interesting as ‘substance’ doesn’t really feature in existing tax treaties. However, as set out below, this increased focus on substance is understandable.

Traditionally, access to treaty benefits depended on two things:

Residence in a treaty state.
Beneficial entitlement to the income or gains in question.

This opened the door to ‘treaty shopping’ - where a company in jurisdiction A, which does not have a tax treaty with jurisdiction B, inserts a flow-through or conduit Special Purpose Vehicle (“SPV”) in jurisdiction C, which does have a favourable tax treaty.

Accordingly, more recently and in particular through the BEPS multilateral instrument, there has been a third requirement for companies to be eligible for treaty benefits:

‘Purpose’, i.e., if the main reason for being resident in a country or holding the asset is to obtain treaty benefits, then that is not acceptable.

Substance though, has not been an overt feature of treaties to date.

Why substance?

If a tax authority is looking to filter out the abusive use of treaties, it is not difficult to see the problems with the above. Most non-tax-haven jurisdictions want companies to be resident. It helps collect tax. Residence is often given based on incorporation, and so is not an obstacle to obtaining treaty benefits. Beneficial ownership and purpose are better filters, albeit they require subjective judgements.

The attraction of substance is that it is tangible, it allows filtering by objective tests. In short, if a company is light on substance, this acts as an indicator that all may not be well on the purpose and beneficial ownership stakes. What this effectively means is that the first use of a substance test is as a ‘warning flag’.

It is a step beyond this to use substance as a stop flag. To say that where you lack substance you are not entitled to treaty benefits introduces a distinction between domestic residence (local taxation) and treaty residence (reduction of cross border taxation).

Practical examples

Within the EU, the February 2019 ‘Danish Cases’ (the company names were never given) led the way in considering a holding company's entitlement to Directive benefits for dividend and income withholding tax (WHT). While these cases focussed on beneficial ownership and abuse of rights, they did set out parameters for identifying conduits which included:

“The absence of actual economic activity must, in the light of the specific features of the economic activity in question, be inferred from an analysis of all the relevant factors relating, in particular, to the management of the company, to its balance sheet, to the structure of its costs and to expenditure actually incurred, to the staff that it employs and to the premises and equipment that it has.”

Although only a small part of the EU Court of Justice ruling, these tests are reflected in later thinking.

In addition to treaty benefits, sometimes domestic exemptions are also available. The Netherlands will give a domestic exemption to certain cross border payments of dividends for example, to the UK, which is now outside of the EU. . However, in giving this exemption, they will apply the Netherlands local substance tests. These include an expectation of local bank accounts, local office premises, local bookkeeping, EUR100k of employee expenses as well as local competent directors.

Surprisingly, these tests are effectively imported into the UK/NL tax treaty where the anti-abuse provision of the MLI is included. In considering this, the Netherlands have said they will apply the same abuse tests, and thus substance requirements, as they do for the domestic rules. The MLI gives the Netherlands the final call on treaty entitlement in an unfortunately worded phrase:

“The competent authority of the [Contracting State] to which a request has been made under this paragraph by a resident of the other [Contracting State] shall consult with the competent authority of that other [Contracting State] before rejecting the request.”

Therefore, we can see a substance test already being applied to deny relief.

And so to ATAD 3 -the ‘unshell’ directive

The EU and OECD have provided tax authorities with various instruments such as the Anti-Tax Avoidance Directive (ATAD), and the Multilateral Instrument to help combat tax treaty abuse. However, since entities with minimal substance and economic activity are supposedly still used for improper tax purposes, the European Commission recently issued a new proposal (ATAD 3).

Taking a step back, we can see that there is a spectrum of substance:

Use of a third party domiciliation agency.
A couple of local professional directors, and perhaps a contract to hire two desks and three filing cabinets whilst outsourcing company secretarial matters.
A small in-house office shared between many companies.
Substantial functions directly employed in-country by the company.

The proposed EU ATAD 3 Directive sets out a number of filters to identify those companies with low economic substance. One target is companies whose management is outsourced. Unless low substance companies can justify their position, the local tax authorities will not issue tax residence certificates, which will likely preclude third countries giving treaty benefits and EU directive benefits will automatically be denied. Even if they can justify their position, they will need to disclose substance information in their tax returns.This information will be available to all EU countries, and any EU state which suspects an entity lacks substance can ask for an audit of its return.

The ATAD 3 indicators are not unfamiliar; employees, premises and qualified local directors. However, as things stand, the directive contains some fundamental flaws, for example:

A derogation based on the undertaking having at least five full-time equivalent staff exclusively carrying out the company’s income generating activities.
A substance requirement based on the company having its own premises, or premises for its exclusive use.

Setting aside what would constitute premises (the toilets, kitchens and entrances discussion) quite simply, these do not reflect typical modern business practice. A high substance multinational or Private Equity (”PE”) platform will often have that substance ‘in country’ but not ‘in company’ for each specific SPV . The draft Directive follows the Dutch approach and allows you to look up to a same country parent for substance but not across a chain or, for a PE house, to a house management company.

These defects can be remedied, and may well have been at the time of reading . ATAD 3 then becomes a viable route to flagging companies meriting further investigation. Those companies not exempt, or able to avail of a derogation must report details of including, but not limited to:

Premises
Revenue
Expenses
Activities
Directors residence and qualifications
Outsourced activities
Bank accounts and who can issue payment instructions.

Being positive, ATAD 3 could be a route to providing clear guidance on substance and common benchmarks across Europe. However, ‘gaming’ the rules is unlikely to be successful. To take an example, the requirement is to report: “bank account number, any mandates granted to access the bank account and to use or issue payment instructions”. A low traffic account, or an account in an EU country where payment instructions are issued from London will simply not pass muster. The Directive requirement is to provide “documentary evidence” in support of the substance.

So ATAD 3 is likely to achieve its goal of defining substance within Europe, and providing a means for comparing across peers. The press release accompanying the first draft Directive promises something similar to address abuse outside of the EU. Whilst hairs may bristle about impinging on tax treaty rights, many already consider the draft ATAD 3 does that and as shown in the Netherlands/UK example, that is quite possible.

Reacting to ATAD 3

Realistically, ATAD 3 does not tell us anything new. For both PE and corporate investors it merely accelerates an existing process of either bolstering substance in a jurisdiction or relocating. The middle ground is simply disappearing. For PE - the UK Qualifying Asset Holding Company (“QAHC”) regime offers an alternative platform, but for corporates, it is not available. Furthermore, having regard to the intention to act against non-EU shells, it would be wise to look at the ATAD 3 substance criteria and ensure your UK or other holding companies meet this.

At the risk of sounding like every other ATAD 3 article, it is important that groups review their structures now, and make decisions on holding company locations and /or explore structures which do not rely on treaty/directive benefits.

Objective tests - where next?

We have flagged that ‘substance’ has not been an historic treaty requirement. It is a proxy for residence and beneficial ownership that can be measured by objective tests. It is not a proxy for ‘purpose’. No amount of ‘substance’ can make good a bad ‘purpose’.

In recent times, the EU has become increasingly attracted to objective tests to flag abuse. DAC 6 reporting is an example. If that, and ATAD 3 are successful, perhaps this could be extended? If we revisit the ‘Danish Cases’ - these were primarily about beneficial ownership.They set out a number of useful tests. These include whether the recipient of dividends is contractually or economically bound to pass these on, whether in practice they almost always do etc. It does not seem too big a stretch to extend ATAD 3’s formulaic approach to encompass beneficial ownership. Purpose remains a subjective test, but those entities with poor purpose will quickly be identified.

Conclusion

Overall, there is a clear direction of travel and the pace is picking up. The OECD’s BEPS report on Treaty Abuse was published in October 2015 and despite the many naysayers, much was achieved quite speedily via the Multilateral Instrument. In the 2020s it seems likely that the EU will be leading the way, and the use of shell entities to game treaty benefits has a very limited lifespan. Companies should be planning on this basis.