The ATAD 3 Directive was proposed by the European Commission in December 2021 with the purpose of preventing the misuse of “shell” entities. It targets EU entities with cross-border “relevant income” (broadly passive income) with outsourced administration and decision-making activities. If the entities lack minimum substance under ATAD 3, they will be seen as a “shell” and denied benefits of EU directives or tax treaties as of fiscal year 2024.

Indicators of minimum substance are: having premises for exclusive use, having an active EU bank account and having at least one director (who cannot be employed by a company outside the group or have director mandates outside the group) or the majority of full-time employees living in the country of the entity in question (or just across the border) and with the appropriate qualifications to exercise their activities.

The set-up of an infrastructure investment often involves establishing entities to address external lending requirements, accommodate co-investors and joint-venture partners with specific rights and obligations and hold multiple investments. The level of substance of these entities varies but as many infrastructure funds are evergreen, their tax strategy needs to be sustainable in the long run.

Entities deemed to have an adequate level of transparency, including companies with listed securities, regulated financial undertakings and holding companies tax resident in the same country as either their shareholder or ultimate parent entity, are excluded from reporting under ATAD 3.

Within an infrastructure investment, the entity receiving cross-border income (“Bidco”) needs to be tested for ATAD 3 purposes. It may rely on the exclusion that it is tax resident in the jurisdiction of its shareholder, but then the latter must meet the indicators of substance or be per se excluded. The exclusion, however, would not apply if Bidco’s (in)direct shareholders are located in different jurisdictions. If Bidco is held by a partnership or contractual fund (which might not be eligible for a tax residency certificate), it or one of its intermediate holding companies should meet the minimum substance indicators required by ATAD 3.

Besides the reporting, the main consequence of ATAD 3 is the denial of exemptions or reduced withholding tax rates on payments (dividends, interest) made to the “shell”. However, the denial of benefits under an EU directive is not a novelty. A number of court cases at local level and at the European Court of Justice (e.g. the “Danish cases”) have been focusing on the substance of intermediary entities and denying benefits.

As of today, many infrastructure funds – especially those investing in long-term assets – should already have a certain level of substance and functions in their location to satisfy target jurisdictions’ substance requirements already in place. The question is whether the existing substance is at the holding entities held by the fund or in a separate entity (e.g. at the AIFM level). Also, funds that take an aggressive position in outsourcing most of their substance will need to revisit their position in light of ATAD 3 and consider solutions that can be sustainable vis-à-vis tax authorities in the long run.

ATAD 3 comes to harmonize the minimum level of substance required. However, with nothing stopping individual countries from setting more stringent substance requirements than those required by ATAD 3, infrastructure funds need to consider whether the existing substance is at the right place and at a sufficient level considering the lifespan of the investments.

Partner, Infrastructure Leader, EY Luxembourg and Patricia Gudino Jonas, Partner, Tax, EY Luxembourg