As Belgium takes over the rotating EU Presidency starting January 1, 2024, one of the six primary thematic areas of focus will be taxation and customs. In this context, a significant emphasis will be placed on measures to combat tax evasion, tax avoidance, and aggressive tax planning strategies, including competition with harmful tax practices. Among these measures, a key initiative will be supporting the implementation of the Unshell Directive (also known as “ATAD 3 Directive”). This move further underscores the critical importance of business substance in the global business environment and highlights the ongoing commitment of authorities to combat the use of shell companies.

This article is written by Rafi Mardroos ([email protected]) and Ariel Hou ([email protected]). Rafi and Ariel are both part of RSM Netherlands International Tax Services with a specific focus on Global Tax Policy and International Tax Advisory. 

In the dynamic landscape of international taxation, the concept of business substance holds significant importance and demands immediate attention. Business substance refers to the presence of operational activities in a particular jurisdiction. The notion of business substance has gained prominence and urgency due to the increased scrutiny by tax authorities on multinational enterprises engaging in profit shifting and base erosion practices. Countries around the globe have been strengthening their regulations and adopting measures to ensure that companies have substantial operations in the jurisdictions where they claim tax benefits. As such a widely known tax concept, substance is especially used in cross-border tax situations. Nonetheless the expression “substance” does not generally appear in the actual text of tax treaties or local tax legislation. There, several other tests are used, such as “residency”, “beneficial ownership”, “qualifying persons” and anti-avoidance provisions such as a “general/principal purpose” test.

As the substance topic continues to evolve, the lack of genuine substance could result in severe consequences, ranging from loss of tax benefits to reputational damage that could hurt the company's standing in the global market. Disregarding business substance not only jeopardizes compliance with tax regulations but also undermines transparency, fairness, and integrity in the international tax system.

On the other hand, the change from "Can company legally do this?" to "Should a company do this?" represents a broader recognition of the ethical and social responsibilities that businesses bear in relation to their tax practices. It acknowledges that merely complying with legal requirements is no longer sufficient, and that companies should also consider the wider impact of their actions on society, stakeholders, and the overall integrity of the tax system.

Impact 

In practice, substance has a significant impact to your business structure in several critical ways that demand your immediate attention, especially for those internationally active enterprises. Firstly, it strongly influences how your organization is perceived, and failure to demonstrate genuine substance could lead to severe credibility issues. Companies must not want to see themselves on newspaper headlines with a substance scandal, as such negative publicity can tarnish their reputation and erode trust among customers, investors, partners, and regulators. They will question your commitment to ethical practices and responsible business operations.

The evolving substance requirements, such as ATAD 3 and the principles of beneficial ownership, are poised to significantly influence its tax position. Lacking substantial presence may hinder your access to tax treaties, EU directives, and incentives provided by governments. The loss of these benefits can put your organization at a disadvantage compared to competitors who meet substance requirements and enjoy preferential tax treatment.

Insufficient substance in your business structure opens the door to potential challenges and disputes with tax authorities.  One of the examples most seen recently in practice is a transfer pricing audit triggered by inconsistency of the level of intercompany prices with the level of substance of the local entity. The implications of such disputes can be financially burdensome and lead to protracted legal battles, which can negatively impact your business operations and resources.

Forward thinking 

Based on the above, it will be clear that maintaining the status-quo of a low substance company is not advised and will invite scrutiny from tax authorities. Instead, the following paths could be considered.

Companies should firstly conduct a gap analysis that will determine the difference between the current level of substance and a 'comfortable' level of substance. The term 'comfortable' is used to underline that it is not the intention to increase the substance to a bare minimum. As reaching a bare minimum would be a short-term quick fix that could still be subject to scrutiny. Instead, a 'comfortable' level of substance is recommended to be defined per case. A mere group financing company could for instance be converted into a central financing entity or cash pool leader of a group cash pooling arrangement, that employs several people with actual decision-making power regarding finances, rather than only paper signing authorities. The same principle could be applied to holding companies.

In case it is not feasible or desirable to increase the substance in the low substance company, it could be considered to shift the holding or finance function to an operational group company within the same jurisdiction or different jurisdiction (within the same region). Subsequently, the low substance company entity may be dissolved as it would become redundant. Lastly, existing, or new employees of said operational company could be tasked to be involved with the holding and financing function which is shifted to said company. In such a case, amalgamation of low-substance activities into an operational company could provide more comfort in practice to be considered a 'bona fide' case, out of scope of (treaty) anti-abuse rules.

By incorporating ethical considerations into decision-making processes, businesses can align their tax strategies with principles of fairness, transparency, and corporate social responsibility. The integration of ESG principles and robust tax governance into the global group’s operations thus serves as a strategic advantage, fostering a balanced and equitable international tax environment to the benefit of all stakeholders.

RSM is Thought Leader in the field of International Tax and Global Tax Policy. We offer frequent insights through training and sharing of thought leadership that is based on a detailed knowledge of regulatory obligations and practical applications in working with our customers. If you want to know more, please reach out to one of our consultants.