Authors: Josef Žaloudek, Kateřina Havlínová in cooperation with Mgr. Martin Blaha, an attorney of the Slovak Bar Association

At the end of 2021, the European Commission presented a proposal for a Directive laying down rules to prevent the misuse of entities that lack sufficient for tax purposes economic substance (so-called “shell entities”). The Directive should be implemented by 30 June 2023 with effect from 1 January 2024. However, given the very fundamental nature of the change, it is essential to prepare now, if only by conducting an indicative initial assessment of which companies in your group may be exposed to the new rules.

The proposed Directive lays down a system of indicators to determine whether or not an entity has sufficient economic substance. Typical indicators that will raise a problem in this respect are (i) the type of income (if more than 75% of it in the last 2 years is from passive sources such as dividends, interest, royalties, lease, insurance, etc.), (ii) paid out or received cross-border, and (iii) “outsourced” management of the company.

If these indicators are met simultaneously, the entity will have to provide additional information (regarding the premises used, the statutory body, etc.) to the tax authority in the tax return. If the additional information shows that the economic substance of the entity is not met, the practical consequence will be, in particular:

• loss of entitlement to any exemption or reduction of withholding tax (in the Czech Republic and Slovakia, income paid to such a foreign entity may be subject to up to a 35% withholding tax in extreme cases);
• “additional taxation” of the tax base of such entity in the state of its controlling company (in the Czech Republic at a tax rate of 19%, in Slovakia at a tax rate of 15%/21%).

Under the proposed Directive, the fine for failure to comply with the reporting obligation or for providing false additional information should be at least 5% of the entity’s turnover.

The whole system proposed by the Directive is very comprehensive, includes numerous exemptions, etc. and can be subject to change. However, it is clear that the “baseline tests” described above may capture a substantial part of e.g., offshore companies.

If you believe that any of your, for example, foreign group companies could become an entity without sufficient economic substance (and thus trigger additional tax obligations in the Czech Republic or Slovakia), please do not hesitate to contact us for further assessment.