So-called phantom foreign direct investment (FDI), often undertaken through shell special purpose entities (SPEs), has declined sharply since 2021, the European Commission said, noting the U.S. Tax Cuts and Jobs Act’s effect on cross-border financial flows.
In 2021 empty SPEs in EU countries "received about 30 percent of the total foreign direct investment. . . . This represents a major fall in both the share and absolute value [of phantom FDI] since 2018, when it was close to 50 percent of the total,” according to a report on global developments in EU capital flows published February 28 by the commission’s Directorate-General for Financial Stability, Financial Services, and Capital Markets Union (DG FISMA) and coauthored by researchers with the Centre for European Policies Studies.
The DG FISMA report notes that the TCJA "is a clear example of a domestic policy change . . . associated with a major and persistent shift in the FDI flows, with large disinvestment on both the EU and U.S. sides.” After a rebound in 2020, the downward trend showed “further signs of amplification in 2023,” it says. The commission said anecdotal evidence also "points to cases of reshoring and redirection of manufacturing activities and investment from China and Europe to the United States, supported mainly through U.S. government policies, such as the Inflation Reduction Act.”
Shell SPEs "are often domiciled either in offshore centers or in countries with a favorable regulatory framework, and they enable their parent companies to move risks away from their balance sheets, as well as to take advantage of the greater confidentiality and tax advantages these jurisdictions provide,” the DG FISMA report says. “This results in the erosion of tax bases of some countries to the benefit of others.” In 2018 and 2019, phantom FDI represented 49 percent and 47 percent of total FDI, respectively, the report's figures show. “The high levels observed in 2018 and 2019 are likely to have been influenced by the U.S. Tax Cuts and Jobs Act and profit repatriation in the United States,” it says.
“Analysis reveals that specific non-EU jurisdictions are actively engaged with certain EU countries that are hosting SPEs and are receiving large inflows of FDI. Russia is notably active in Cyprus, and China has a significant presence in Hungary," the report says. "In Luxembourg and the Netherlands, 'other countries' — comprising various small nations and offshore financial centers — turn out to be the largest ultimate investors.”
The report says Luxembourg receives as much FDI as the United States, and much more than China, based on data up to 2018. “There is no doubt that not all of this FDI is genuine investment,” it says.
The issue of phantom FDI came up in the now-stalled negotiations on the draft Unshell directive, which is intended to tackle the misuse of shell entities. The impact assessment for the proposed directive suggested that “an upper bound of the current EU-wide tax loss sustained through the use of SPEs could amount to around €60 billion per year,” of which €40 billion stems from investors outside the EU. “These figures stem almost exclusively from those two EU countries showing by far the highest inward FDI in SPEs and income flows (and thus, imputed forgone tax revenue): the Netherlands and Luxembourg,” the impact assessment says.
The Unshell proposal excluded regulated financial entities. “A few delegations have strongly argued for the inclusion of special purpose vehicles" — entities that are at least 95 percentowned by alternative investment funds or undertakings for collective investment in transferrable securities (UCITS) — "in line with the approach taken in pillar 2 in the definition of regulated financial entities,” the EU Council’s former Spanish presidency said in a note dated September 2023, when Unshell was still being negotiated. Including those SPEs in the definition of regulated financial entities would effectively exempt them from Unshell.
The commission supported exempting those SPEs from the Unshell directive in the negotiations in September 2023, not only because that would align Unshell with pillar 2, but also because those entities are subject to indirect supervision. For example, UCITS managers have an obligation to provide specific information on SPEs to supervisory authorities. Furthermore, because one of the main purposes of SPEs is to limit risks, those entities could easily rebut a possible presumption under the Unshell directive that they are shell entities, the commission said.
However, it is not clear if or when the Unshell negotiations will resume, as the EU Council’s Belgian presidency said it wants to reflect on how to move forward.