Portugal: the unshell directive proposal and the quest for economic substance
Francisco Cabral Matos and Guilherme Lourenço Baptista of VdA outline Portugal’s efforts to demystify the concept of economic substance for tax purposes.
The unshell directive proposal was published in December 2021 with the EU Parliament endorsing it last November, while a final decision from the EU Council is still pending. The EU Council flagged that the success of this initiative would require further technical work to obtain consensus among EU member states. After successive postponements, it is yet unclear if and when the unshell directive is going to be adopted.
The unshell directive addresses in detail, for the first time within EU legislation, the concept of economic substance and the objective criteria to assess it. Given the multitude of activities and different business models (especially with the advent of the digital economy and remote working), this task is quite challenging. Most EU member states lack any domestic guidance on the matter and Portugal is among those.
Portugal: tax residency definition
In Portugal, the concept of tax residence encompasses the corporate seat and the “place of effective management” as two alternative criteria. Being alternative criteria, Portuguese legislation accommodates both a formal and a substance approach to ascertain its taxing jurisdiction – the substantive approach prevailing only if a double tax treaty tie-breaker rule comes into play.
A registered office is set out in the statutes of the legal person and corresponds to a physical location. From a corporate law standpoint, no minimum requirements are set in respect of the characteristics of this location, thus there is no link between the headquarters of a company and its (effective) business activity.
Regarding the “place of effective management” concept, Portuguese tax authorities and courts have interpreted said concept as the place where the company’s senior management has a fixed place and operates on a regular basis, where the main decisions are taken, notably regarding commercial and business strategy. In the definition of “place of management”, Portugal generally follows the OECD guidelines.
Substance over form: standard vs. anti-avoidance rules
Based on a continental/civil law framework, the Portuguese legal system relies primarily on written provisions. Tax provisions are applicable insofar as reality meets the requirements and conditions foreseen in the law and that transactions meet the legally described characteristics. As such, the interpretation of tax provisions departs from a formal approach. Substance-over-form is typically triggered by the application of special provisions, notably the general anti avoidance rule (GAAR) or specific anti avoidance rules. Thus, in principle, one resorts to a substantive approach if there is no perfect match between the fact pattern and the wording of the law (e.g., situations not clearly addressed by the written provisions) or when there seems to be an abusive application of certain provisions (maxime fraus legis).
Interestingly, while tax residence is a core concept when ascertaining tax jurisdiction, Portuguese law does not detail how to assess the de facto tax presence of a legal person in Portugal. Neither did Portuguese tax authorities publish guidance on which basic requirements should be verified for a legal person to be deemed (or recognised as) resident in Portugal.
This fits a more general challenge regarding the correct application of tax provisions, as there is no uniform way of defining “economic substance”. Economic substance is referred to mostly in anti avoidance provisions and often replicating the exact wording of EU legislation on the matter, without adding any flavour to it that could be used as an interpretation aid. This is the case, for instance, with the references to the concepts of “genuine transactions” and “economic reality” that are replicated from the EU Parent-Subsidiary Directive, or ATAD 1.
Beneficial owner: territory base criteria?
Cross-border transactions also trigger the analysis of beneficial ownership. Portuguese tax authorities have been increasingly focused on this matter, denying the benefits of double tax treaties and EU directives to investors that do not evidence a satisfactory level of economic substance. Again, tax authorities resort to criteria such as the number of staff, the existence of own premises and the degree of physical presence of an entity in its country of residence, to decide whether a withholding tax exemption (or reduction) may be accepted in Portugal. And the recent track record shows that not only Portuguese tax authorities are conservative on their approach, but also Portuguese tax courts seem willing to back said position (as reported in the articles of our colleagues Miguel Amado and Vitor Loureiro e Silva - here and here).
The above is giving rise to an inconsistent outcome. While taking a harsh position towards the level of economic substance of non-resident entities, companies incorporated in Portugal are awarded by Portuguese tax authorities with a tax residence certificate without any preliminary assessment of their substance. Such an approach is partly a result of the lack of guidance or clear policy regarding cross-border transactions, but also based on a pure treasury perspective. It ensures the collection of income taxes on both ends: corporate income tax due by Portuguese incorporated companies “no matter what” and withholding taxes from payments to (potentially) shell companies established abroad.
However, in doing so, Portuguese tax authorities may be overlooking that this may well weaken their position in future tax disputes. By challenging a foreign company which, if resident in Portugal for tax purposes would be fully recognised, Portuguese tax authorities are piercing the basic principle of equal treatment.