Changes to Portuguese participation exemption

Taxpayers hope that the new regime is reviewed soon and drastic changes are made

Portugal introduced some important amendments to the its participation exemption regime on distribution of dividends in the 2011 State Budget Law. The practical effect of the new rules is that shareholdings of less than 10% in the share capital of subsidiaries are no longer eligible for the exemption on dividends under the regime (while previously, the regime would apply where the shareholding had been acquired for at least €20 million($26.8 million) or, irrespective of the percentage or value, was held by a Portuguese pure holding company (SGPS)).

As expected, these new rules have had a significant impact on the taxation of dividends and in particular on the taxation of dividends distributed by listed companies. These amendments caused much controversy in Portugal, aggravated by the fact that some major listed companies anticipated distribution of dividends to 2010. Remarkably, this was interpreted by government officials (including the Portuguese prime minister and the minister of finance, in several rare public statements) as an abusive manoeuvre aimed at avoiding the application of the new rules. Discussions were held on the possibility of anticipating the application of the new rules to 2010 so that these anticipated dividends would not avoid being taxed, and several alternatives were considered (such as the application of the new rules to all dividends distributed in 2010). However, parliament and the government ultimately opted out of opening a new front, possibly because they anticipated problems in the form of complaints by major Portuguese players for breach of the Portuguese Constitution (which expressly forbids the retrospective application of tax laws) and of potential complex legal proceedings. In this regard, the participation exemption regime was brought to the attention not only of the general public in Portugal, but also of foreign investors that may be affected by the application of the new rules.

The Portuguese Corporate Income Tax (CIT) Code establishes mechanisms for the avoidance of double taxation occurring when a company distributes dividends arising from profits that were already subject to taxation. Until 2000 the method consisted of a 95% deduction of the dividends included in the taxable base of a taxable person for CIT purposes. However, in 2000, a full deduction system was introduced, under which parent companies can, in general, deduct from their taxable base 100% of dividends that they receive, according to the following rules.

Under the applicable rules, dividends paid by a Portuguese company to another Portuguese company are fully deductible from the taxable base of the beneficiary entity, provided that the following conditions are met:

• The subsidiary is subject to, and not exempt from, CIT;

• The beneficiary company is not subject to the tax transparency regime; and

• The beneficiary company directly owns at least 10% of the subsidiary's share capital (until December 31 2010, a shareholding of at least 10% or with an acquisition cost of at least €20 million qualified for the participation exemption regime) for an uninterrupted period of at least one year (this requirement can be met after the dividends are distributed).

As regards dividends obtained by insurance companies and mutual insurance companies (regarding shares acquired with technical reserves), regional development companies, investment companies and financial brokerage companies, the 100% deduction does not depend on the last requirement referred to above.

Under the new rules, when the dividends derive from profits that were not subject to effective taxation, no deduction will be allowed (until December 31 2010, the deduction was reduced to 50% if, in general, the relevant dividends derived from profits that were not subject to effective taxation or if the beneficiary company did not satisfy the conditions mentioned in the second or third points above).

Furthermore, dividends arising from shareholdings in the share capital of an EU resident company can also benefit from a special tax regime. In fact, a Portuguese resident company can deduct from its taxable income 100% of the value of the dividends distributed by EU resident companies, in the same way as for dividends distributed by Portuguese resident companies (provided that the EU resident company complies with all the conditions referred to in article 2 of Council Directive 90/435/EEC – Parent-Subsidiary Directive).

The same rules apply to dividends arising from a shareholding held in a company resident in the European Economic Area (EEA), provided that its state of residence is subject to exchange of information obligations with Portugal similar to those established under EU law, and to the extent that the paying company complies with requirements and conditions equivalent to those foreseen in article 2 of the Parent-Subsidiary Directive.

Portuguese permanent establishments of EU or EEA companies (in this case, provided that the state of residence is subject to exchange of information obligations with Portugal similar to those established under the EU) may also benefit from the participation exemption regime in the terms set out above.

The rules also apply to liquidation proceeds that qualify as investment income such as the difference between the market value of the assets attributed to each shareholder and the value which, according to the company's accounts, corresponds to the effective subscriptions of the shareholders to the share capital.

Finally, dividends distributed by companies resident in Portuguese-speaking African countries or in East Timor may also be deducted to the taxable base of Portuguese resident companies provided that certain conditions are met such as that the relevant shareholding is of at least 25% and held for two years and that the dividends arise from profits that were subject to a tax rate of at least 10% and the profits do not result from passive income such as royalties, capital gains and other income arising from securities etc.

Another amendment introduced by the State Budget Law in relation to the issue under analysis consists of a new rule that establishes that capital losses arising from the transfer of shareholdings are not deductible for tax purposes up to the amount corresponding to related distributed dividends that were not subject to taxation under the regime in the previous four years. The other conditions for the deduction of capital losses will continue to apply.

Dividends and liquidation proceeds that qualify as capital income paid by Portuguese resident companies to non-resident companies are in general subject to withholding tax at a final rate of 21.5% (until December 31 2010 the applicable rate was of 20%). This rate may be reduced by the application of a double tax treaty (usually to rates of between 10% and 15%).

However, dividends paid to an EU company, an EEA company (provided that the state of residence is subject to exchange of information obligations similar to those established under EU law), or to a permanent establishment located in another EU or EEA member state which has its head office in another EU or EEA member state which is subject to exchange of information obligations similar to those established by EU law, are not subject to taxation in Portugal (whether withholding or final), provided that the following conditions are met:

• Both companies are subject to one of the taxes on profits listed in article 2c of the Parent-Subsidiary Directive or, for companies resident in an EEA member state, a similar tax;

• The profit distribution does not result from the liquidation of the Portuguese company;

• The beneficiary company directly owns at least 10% of the subsidiary's share capital (again, until December 31 2010 a shareholding of at least 10% or with an acquisition cost of at least €20 million qualified for the participation exemption regime)) and an uninterrupted holding period of one year is fulfilled before the distribution of the dividends; and

• The non-resident entity provides evidence, before payment, that it qualifies for the purposes of the Parent-Subsidiary Directive or similar requirements, through a declaration issued and confirmed by the corresponding tax authorities, valid for one year.

Furthermore, dividends paid by Portuguese resident companies to Swiss resident companies are also not subject to taxation in Portugal, according to the agreement between the European Community and the Swiss Confederation providing measures equivalent to those laid down in Council Directive 2003/48/EC on taxation of savings income in the form of interest payments, provided that certain conditions are met such as that the relevant shareholding is of at least 25% and held for two years.

In both of the above cases, if the holding period has not been fulfilled when the dividend is paid or if the evidence referred to above is not provided before the payment of the dividends, the refund of the withholding tax levied in excess may be claimed when the holding period is fulfilled or evidence is provided, within two years as from the date on which the holding period was fulfilled.

Finally, under the new rules, where a EU or EEA entity is subject to a final taxation on dividends in Portugal that exceeds the tax that would due be according to the general CIT rates (up to a maximum of 29%) a refund of the difference can also be requested.

Portuguese pure holding companies (SGPS) benefit from the general participation exemption rules (until December 31 2010, a SGPS could deduct from its taxable income an amount equal to 100% of the value of the dividends obtained from a shareholding held in qualifying companies, provided that the shareholding was maintained on an uninterrupted basis for at least one year, regardless of the percentage of the shareholding held in the company paying the dividends).

Furthermore, capital gains or losses obtained by SGPS companies from the disposal of shareholdings held for a minimum period of one year (or, in some cases, such as shareholdings acquired from related entities or entities resident in a tax haven or where the SGPS was originally incorporated as a normal company, three years since the acquisition or transformation), as well as any interest or other financial costs incurred for the acquisition of those shares, are not included in its taxable income.

It should be noted that the rules on outbound dividends applicable until December 31 2007 were referred to the European Court of Justice (ECJ) by the Portuguese courts on several occasions. In fact, the requirements for the application of the tax exemption on outbound dividends were stricter than the requirements for the application of the domestic or inbound dividends, as, in the former, a shareholding of 15% held for two years was required for the exemption to apply (20% until 2006). These cases are still to be decided, but the ECJ is expected to consider that the previous rules were in breach of EU law.

In this regard, it should also be noted that, until 2010, certain features of domestic and inbound dividends rules were more favourable than those of outbound dividends. In fact, and as mentioned previously, Portuguese resident entities were allowed a deduction of 50% of the dividends when certain of the requirements for the application of the participation exemption regime were not met. In these cases, and in view of the applicable tax rates until early 2010, Portuguese resident entities could be taxed on such dividends at an effective rate of 12.5%. However, this treatment was not extended to dividends paid by Portuguese resident companies to EU or EEA companies, which could be subject to withholding tax at a rate of 20% (or a reduced double tax treaty rate). Therefore, whenever EU or EEA companies are subject to an effective tax rate higher than 12.5%, a discrimination could be deemed to be taking place and, therefore, Portuguese law could also be considered in breach of EU law such as the freedom of establishment or the free movement of capital rules, especially, when the withholding tax is not recovered by the receiving companies according to a double tax treaty entered into by Portugal and the relevant member state.

Even if these cases may have been resolved by the new rules (since the 50% deduction is no longer in force), there is still some margin to discuss dividends that were distributed in the past (in the tax periods open to audit, that is, the last four years).

Finally, in our view, a clear breach of EU law remains unsolved. As mentioned previously, liquidation proceeds derived by Portuguese resident companies that qualify as capital income may benefit from the regime, provided that the relevant conditions are met. This does not apply to liquidation proceeds distributed by a Portuguese company to an EU or EEA company. Even if it can be argued that, as the Parent Subsidiary Directive does not cover liquidation proceeds, the Portuguese state is in full compliance with EU law, the ECJ has consistently stated that the fact that a specific directive provides only a minimum protection does not allow member states to discriminate non-resident entities on matters that are not covered by direct tax harmonisation. Therefore, we consider that the Portuguese state is in breach of EU law in this respect, without any of the usual justifications being valid on this occasion.

As referred above, the new rules entered into force on January 1 2011. No transitory provisions were adopted. In our opinion, the previous rules should continue to apply to dividends distributed in 2010, even where the one year holding period has not elapsed before December 31 2010, that is, where tax was initially withheld because the one year period had not elapsed, the refund of said tax should be made by the tax authorities once said period has been completed according to the rules in force at the date of the distribution of dividends.

The Portuguese tax authorities have not yet publicly provided any clear guidance on the concept of effective taxation, which has become under the new rules even more vital for the application of the regime. It is not clear, for instance, if the application of a reduced rate, the partial taxation of profits such as only part of the profits being subject to taxation while the other is exempt or the effective taxation at the level of a sub-subsidiary are considered effective taxation. In our opinion, all should be considered as profits that were subject to effective taxation. In any event, and even if there are some cases (not publicly disclosed) in which the tax authorities have acknowledged that effective taxation at the level of a sub-subsidiary is sufficient for the purposes of the rule, the need for some guidance on this issue has now become of essence.

It should also be noted that the effective taxation rule should be considered aimed at preventing tax abuse. Under the Parent-Subsidiary Directive, member states are in fact allowed to apply domestic or agreement-based provisions as necessary in order to prevent tax fraud or abuse.

However, in view of the ECJ's judgment in respect of similar rules established in the Merger Directive (Case C-28/95 – Leur-Bloem), it is our opinion that where the Parent-Subsidiary Directive is applicable, any provision automatically disallowing the deduction where the underlying profits were not subject to effective taxation should be considered as contrary to the directive. In fact, the above mentioned rule consists of a general provision that does not require a general examination (that is open to judicial review) of the operation in each particular case by the tax authorities and which automatically excludes certain transactions from a domestic tax benefit, regardless of whether or not there is actually tax evasion or tax avoidance.

As to the amendment to the SGPS tax regime, there are arguments supporting that the new rule should not apply to shareholdings held by companies incorporated before January 1 2011. In fact, the SGPS regime is construed under the Portuguese Tax Benefits Law as a temporary tax benefit, as it should expire on December 31 2011 (even if the benefit is expected to be renewed). Under that law, the revocation of temporary tax benefits does not apply to persons or entities that have already acquired the right to such benefits, unless otherwise established by law.

In this regard, companies that have been incorporated as a SGPS are subject to a strict legal regime (as a general rule, SGPS are not allowed to dispose of or grant guarantees over shareholdings before a year has elapsed since acquisition, they are subject to restrictions on granting of credit and are not allowed to carry out any direct economic activities). As such, when investors choose this form of company they are expecting several restrictions to the company's activity, but also an attractive and stable tax regime and that the applicable tax benefits are maintained for the period for which they were initially granted. Unfortunately, we do not expect the Portuguese tax authorities to share this view.

In our opinion, the outcome of these amendments is very negative. The new rules increase the gap between the already feeble Portuguese participation exemption regime and that of other EU countries that are much more appealing for investors. Many Portuguese holding companies are expected to transfer their shareholdings or simply move to more attractive jurisdictions. Furthermore, from the perspective of non-resident investors, which should in the current situation be treated thoughtfully by Portugal, the idea of investing in the country becomes increasingly less appealing, due both to the instability of Portuguese tax law and to the fact that investments are simply becoming unattractive from a tax point of view. These new rules should therefore be reviewed as soon as possible by the Portuguese government, even if this is unlikely to occur soon due to the fiscal restrictions that Portugal is experiencing.