Spanish participation exemption confirmed as full rather than partial for CFC regime

Controlled foreign company (CFC) regimes are traditionally anti-abuse rules aimed at avoiding the deferral of taxation of income – normally of a ‘passive’ nature – in controlled foreign entities resident in territories with nil or low taxation. Accordingly, in any CFC regime, at least the following requirements should be met with respect to the corresponding foreign subsidiary:

• Control over such company; and

• Lower taxation of such company compared with that which would apply if it were resident for tax purposes in the territory in which its parent entity is resident.

In relation to the second requirement, Article 100.1(b) of the Spanish Corporate Income Tax Law (the CIT Law) requires a comparison between the effective taxation borne by the foreign subsidiary and the taxation that would have been borne by the same company had it been resident in Spain. If that comparison shows that the taxation of the non-resident subsidiary is 75% lower than the taxation that would be applicable in Spain in relation to the income in question, and the rest of the requirements are met, the corresponding income must be reported under the Spanish CFC regime.

For tax periods commencing on or after January 1 2021, the exemption regime provided for in Article 21 of the CIT Law was amended in the sense that the amount of dividends and positive income obtained on a transfer of shares to which the exemption of Article 21 applies should be reduced by 5% as management expenses. In practice, this income is generally taxed in Spain at 1.25% (a tax rate of 25% applied to 95% of the income).

The introduction of this legislative amendment opened up two interpretations as to the nature of the exemption in Article 21 of the CIT Law:

• It was a rule that limited the amount of the exemption quantitatively (to 95%) (i.e., we were dealing with a ‘partial exemption’); or

• It was a rule that restricted the deduction of certain expenses, estimated on a notional basis at 5% of income, but without affecting its full exemption status.

The aforementioned technical discussion on the nature of the exemption could have an impact on the application of the Spanish CFC regime by a Spanish parent company participating in foreign entities through an intermediate holding entity.

The Spanish Directorate General of Taxes (DGT) has finally shed some light on this debate and issued a binding resolution, V2138-24, of October 3, on the matter, stating that the exemption provided for in Article 21 of the CIT Law is a full exemption that must be applied to the income corresponding to the dividends received or capital gain obtained (income that is determined by deducting the corresponding management expenses).

In accordance with this interpretation, the DGT concludes that, in the case in question (a Spanish holding company holding 96% of a Chilean holding company that receives dividends from its operating subsidiaries, which are 100% exempt in Chile), it will not be understood that the dividends obtained by the Chilean holding company have been taxed at less than 75% of the taxation that would have corresponded in Spain, since in both countries such income has a full exemption. Therefore, the DGT concludes that there is no obligation to declare those dividends under the Spanish CFC regime.

The recent DGT ruling provides clarity and legal certainty on an issue that had generated a high level of technical discussions since the introduction of the rule limiting the deduction of portfolio management expenses in the participation exemption regime under Article 21 of the CIT Law.