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The Non-Habitual Resident regime: an American oasis?

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Francisca Osório de Castro of Morais Leitão overviews recent case law that could have a significant impact on American nationals’ tax regime in Portugal.

An oasis for American nationals who benefit from the Portuguese Non-Habitual Resident tax regime (NHR regime) may be on the horizon, in light of the Arbitral Court’s decision on case no. 684/2020-T.

The NHR regime is a favourable tax regime designed to attract professionals performing high added-value activities to Portugal, as well as high net-worth individuals. In short, depending on the types of income received by the taxpayer, the NHR may allow for the possibility of lesser taxation or full exemptions on foreign income.

According to Portuguese law, for foreign income received by the taxpayer to be exempt from personal income tax in Portugal, said income must be taxable in the other contracting state. This is according to the relevant Double Tax Treaties (DTT), or, in the absence of one, according to the OECD Model Tax Convention (OECDMTC), so long as said state is not considered a tax haven in Portugal.

Therefore, considering the configuration of most DTTs and the OECDMTC, passive income – such as interest, dividends and royalties – will usually benefit from the exemption, as the taxing right is allocated to the source state. However, such is not usually the case for capital gains, considering that the right to taxation is generally allocated to the residence state. Therefore, taxpayers who benefit from the NHR regime have grown used to seeing their capital gains be subject to taxation in Portugal. Considering the court’s decision, that paradigm may change in the case of American nationals. Here’s why:

An American national who resides in Portugal and benefits from the NHR regime obtained income arising from both France and the US derived from the sale of securities, i.e., capital gains, both of which were effectively taxed in the US. The tax authorities considered that, since according to the relevant DTT, capital gains can only be taxed in the residence state, said income should be taxed in Portugal. The court, however, decided differently, granting an exemption on both US and France-sourced income.

The reasoning of the court is as follows. Concerning the US-sourced income, the court noted the existence of a “saving clause” in the Protocol between Portugal and the US, which is an integral part of the DTT entered into by the two states, which states that the US “may tax its citizens, as if the Convention had not come into effect”. Considering that the US’s tax system allows for taxation based on nationality – regardless of the residence of the taxpayer and of the source of income – the court found that the US-sourced capital gains are indeed taxable in the US, regardless of the taxing right allocation foreseen in the DTT and should therefore be exempt in Portugal.

The Court’s reasoning is sound, as, in effect, the Protocol establishes said taxation right. Furthermore, relevance seems to have been given to the fact that the income in question was effectively taxed in the US. In theory, however, the effective taxation is not required by the NHR regime and should not in principle influence the right to an exemption.

The Court’s position on the France-sourced income is however, by the Court’s own admission, less direct. In fact, according to the NHR regime, to grant the right to an exemption on foreign sourced income, one should look to the DTT entered into by the residence and the other contracting state, usually understood to be the source state.

As mentioned, the DTT between Portugal and France allocates the capital gains taxing right exclusively to France. The Court, however, decided that the existing DTT (and Protocol) between Portugal and the US could not be ignored, as in the Court’s opinion it generates a so-called triangular regulation of taxation rights. As such, the US should also be seen as a “contracting state” for the purposes of the application of the NHR regime.

Therefore, the Court, however conscious that another interpretation would be possible considering the letter of the law, considering the regime’s purpose, argued that the income should be considered taxable in the “other contracting state” (the USA), and granted the exemption.

Once again, the fact that the France sourced income was effectively taxed seems to have weighed in (even more so) on the Court’s decision, with mentions of equity along the way. In the Court’s words: “No justification can be found to apply the tax exemption method to situations only susceptible to taxation abroad, and not apply it in cases where such taxation was effectively carried out in the USA. Otherwise, there would be a differentiated and unfavorable treatment of U.S. citizens, without any justifiable reason”.

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