Portugal's 2008 State Budget Law (Law 67-A/2007, of December 31), introduced a substantial amendment to the taxation of income arising from swap transactions (exchange rate swaps, interest rate swaps and interest rate, currency and foreign exchange swaps, as well as currency forwards), dramatically changing the tax framework of the majority of financial derivative products in Portugal.
As expected, this change created numerous negative consequences for derivative transactions, affecting crucial domestic and international players in the derivatives markets such as financial institutions, local companies, investors, state-owned entities, municipalities and the autonomous regions of Madeira and the Azores.
However, and to the satisfaction of such derivatives market participants, the new State Budget Law for 2009 is reverting to the tax treatment that gains from relevant swap transactions had before the 2008 Budget Law change.
Income arising from derivatives in Portugal, especially income arising from exchange rate swaps, interest rate swaps and interest rate, currency and foreign exchange swaps, as well as currency forwards, is deemed "income on capital" and is taxed depending on certain circumstances.
Income earned by a resident company from these products may be subject to withholding tax at a rate of 20% and are taxed as capital income, as follows:
- currency swaps and forward exchange agreements – the taxable income corresponds to the positive difference between the agreed exchange rate established for future sale or acquisition and the spot exchange rate on the contract date for the same monetary unit;
- interest rate swaps and cross currency interest rate swaps – the taxable income corresponds to the positive difference between, respectively, the interest and the foreign exchange gains regarding the exchanged capital. However, on the one hand, no withholding tax is due if the beneficiaries of the income are financial institutions subject to corporate income tax on the interest or other capital income obtained, except for distributed profits, even when they are exempt; or entities entitled to total or partial corporate income tax exemption in relation to interests that would have been subject to withholding tax, provided that proof of the exemption is presented to the payment agent.
On the other hand, income earned from exchange rate swaps, interest rate swaps and interest rate, currency and foreign exchange swaps, as well as from currency forwards by a non-resident company is subject to a final 20% withholding tax, whenever due by a Portuguese resident entity or by a non-resident entity with a permanent establishment in Portugal responsible for its payment. In any case, if the investor is a resident in a country with which Portugal has a double taxation agreement, and is entitled to the benefits provided for in such treaty, this income may only be taxable in the investor's country of residence, rather than in Portugal. This is the typical alternative structure that was used to avoid the withholding tax on gains payable by a non-financial Portuguese counterparty and the major economic inconveniences of the contractual "gross-up" provisions.
|General tax framework|
|Under the Corporate Income Tax Code, Portuguese companies are subject to corporate income tax at a rate of 25% (an additional municipal surcharge - maximum 1.5% - applies, leading to a maximum final rate of 26.5%) on all of their income while foreign companies are subject to corporation income tax if they carry on a trade in Portugal through a permanent establishment. In certain specific cases even when a permanent establishment does not exist, foreign companies may be subject to withholding tax. Taxable profits of a Portuguese company consider mostly the accounting profit, which is determined in accordance with either International Financial Reporting Standards (IFRS) or Portuguese Generally Accepted Accounting Principles (GAAP). The taxation of many items should in general "follow the accounts", although adjustments may be required.|
And gains by non-resident financial institutions from swap transactions carried out with resident credit institutions are exempt from corporate income tax. However, this exemption will only apply if the gains are not allocated to a permanent establishment in Portugal of those institutions. Additionally, there is also a tax exemption with respect to gains obtained by non-resident financial institutions from swap transactions entered into with the Republic of Portugal (duly represented by its debt agency – IGCP) if those gains are not allocated to a permanent establishment in Portugal.
Budgets – 2008 vs 2009
The 2008 State Budget Law introduced substantial amendments to the taxation of income arising from swap transactions by changing section 5 of the personal income tax code and assimilating the gains deriving from them to interest income. Consequently, the amendment in the tax law requires local non-financial counterparties to withhold tax when entering into certain swap transactions with non-resident financial institutions where before such a withholding did not apply.
The Portuguese state's purpose was to increase tax revenues by having these gains subject to withholding tax in Portugal even when earned by residents in countries which have entered into a tax treaty with Portugal. This was carried out by retaining the existing withholding situations, and also extending them to cases where the relevant beneficiary was a financial institution resident in countries with which Portugal entered into a tax treaty.
The negative impact of the change on derivative transactions led several international and domestic players in the derivatives market, as well as the International Swaps and Derivatives Association (ISDA), to argue against the amendment. They emphasised that Portugal's move clearly contradicted not only the market trend but also previous administrative tax doctrine, the expressed opinion of the OECD, EU principles and the practice followed by most other countries.
All these market players and entities also agreed that Portugal should re-establish the previous existing tax environment urgently.
Meeting the minister
A delegation from these market players met Carlos Lobo, the new secretary of state for tax affairs, in April 2008 and followed this up with a report, pointing out the inconveniences of the new legal regime, including statements from both domestic as well as international players, indicating particular claims and specific damages.
All entities involved in this process were very optimistic that section 5, number 10 of the state budget law would be abolished.
However, to extend the suspense on what now tended to become a tax thriller, despite several other positive tax measures, such as the extension of the existing withholding tax exemption for swap transactions between non-resident and domestic financial institutions to income arising from currency forward transactions between financial institutions, the Proposal of Law for the 2009 state budget presented by the Portuguese government on October 15 2008 did not revisit the tax amendment and thus did not abolish the assimilation to interest of the income arising from certain swaps.
Some market players did not lose hope and continued to press for a market oriented regime. Finally, on November 28, in the final article-by-article voting stage of the state budget proposal for 2009, the government majority in the Portuguese Parliament approved the removal of Section 5, number 10 of the personal income tax code.
With the promulgation on December 30 by the President of the Republic of the Budget Law for 2009, as of January 1 2009, income deriving from relevant swap transactions will recover the same tax treatment in force before the 2008 Budget Law and thus gains deriving from the relevant swap transactions will merely be deemed income on capital (individual income tax – category E).
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Hence, in cases where a double tax agreement applies and depending on each specific case, a swap transaction gain will be considered as "business profit" or "other income". Consequently, clauses 7 or 21 of the double tax agreement shall apply, meaning that in some cases the swap payments will not be subject to withholding tax in Portugal and will only be taxable in the state of residence of the payer.
Spanish tax law does not specifically provide for a definition of derivative contracts. Nevertheless, Spanish accounting legislation applicable to financial institutions and to non-financial entities defines derivative contracts using an IFRS (International Financial Reporting Standards) perspective.
Turning to the withholding tax context, income earned from a derivative by a Spanish resident counterparty or by a non-resident entity with a permanent establishment in Spain would not be subject to withholding tax in Spain. For non-resident income tax purposes (non-resident acting without a permanent establishment in Spain), derivatives income may be considered as business income or as capital gains.
However, if a double tax agreement applies derivative income should not be taxable in Spain taking into consideration that double tax agreements that follow the general guidelines of OECD model conventions provide that, as a general rule, capital gains (with certain exceptions) and business income not obtained through a permanent establishment should be taxable only in the state of residence, and not in the state of source. Hence, generally no non-resident income tax and no Spanish withholding tax apply to derivative income obtained by residents in countries with which Spain entered into a double tax agreement. Finally, if no double tax agreement is applicable, such income would be subject to taxation at the applicable rate (24% for business income and 18% for capital gains).
In the UK there are specific and complex tax rules governing the taxation of derivatives. These tax rules usually attempt to ensure that a company is taxed on its derivative contracts in line with the accounting treatment (that is, debits and credits on derivatives arising in the accounts, regardless of whether they are included in the profit and loss or income statement). Although there are exceptions, the rules generally provide that derivatives are taxed as income. Furthermore, on payments made in relation to derivative contracts there is a specific exemption from withholding tax.
There are no specific tax rules regarding derivatives taxation in Luxembourg. Consequently, the tax treatment of income arising from derivatives should follow the profit and loss recognition generally accepted under the Luxembourg accounting treatment. Pursuant to article 40 of the Luxembourg income tax law the tax balance sheet is established following the commercial balance sheet. As a consequence, the tax treatment of derivatives in Luxembourg (that is, the recognition of income and expenses for tax purposes) should follow the accounting treatment accepted for such derivative instruments. Additionally, there is no withholding tax on payments made in relation to derivative instruments.
The French tax code does not present any general definition for derivatives, but does include a few special rules applicable to them. For taxation purposes, gains and losses on derivatives are taxed as ordinary business income and losses. Regarding withholding tax, no French withholding tax applies to domestic payments.
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In addition, there is no specific provision in the tax code which clearly deals with cross-border payments on derivatives, but in practice no withholding tax has been applied. In January 2008, the French tax authorities issued specific guidance confirming that cross-border payments on interest-based derivatives are not within the scope of withholding tax on interest.
In Switzerland there are generally no special rules regarding the taxation of derivatives. The derivatives tax treatment is based on the accounting treatment according to the Swiss statutory accounts. Gains and income derived from derivatives owned by one company and shown in its profit and loss account are subject to corporate income tax at the applicable rate.
Accordingly, the Swiss withholding tax treatment of derivatives applies a withholding tax at a rate of 35% on dividends distributed by Swiss companies to its shareholders and on interest paid on bonds, serial promissory notes, serial mortgage notes/registered notes and on client deposits with Swiss banks. Where a payment under a derivative qualifies as a dividend or as interest relating to a bond or a bond-like instrument, then withholding tax is due.
Generally, no withholding tax is applicable in connection with financial derivative instruments such as options and futures on foreign exchange or interest rates. In any case, a Swiss-resident company can claim a full refund from the withholding tax and a non-resident entity can claim full or partial relief of the withholding tax under the provisions of a treaty, if available.
While there are no specific tax rules regarding the taxation of derivatives, Irish tax provisions authorising the use of accounting profits are supported by a number of Revenue Statements of Practice in relation to specific derivative types (for example, swaps).
Withholding tax may be imposed upon interest or annual payments, but in the case of swaps, credit derivatives, forward rate agreements and other derivatives the compensatory/equalisation payments are not regarded as having either the nature of interests, or of annual payments (as they do not consist of pure income profit). Accordingly, no withholding tax duties arise with respect to such payments.
Generally, there are no specific rules in the German tax legislation that deal with the taxation of derivatives for companies. Consequently, general tax principles are applicable and the tax treatment of derivatives principally follows the accounts: the Accepted German Accounting Principles. However, specific rules may apply regarding hybrid instruments, derivatives used for hedging purposes or derivatives trading books. Generally, income received from vanilla derivatives is not subject to withholding tax. In relation to certain structured notes which are typically a combination of a bond and a derivative instrument, withholding tax may be imposed where the instruments are regarded as so-called "financial innovation".
Under the Business Tax Reform Act 2008, as of January 1 2009 corporations will in general be exempt from withholding tax in respect of derivative income (including realised capital gains from financial innovations).
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However, other investor types will then be subject to withholding tax at a rate of 26.375% on income payments from derivatives, including capital gains from financial innovations, if the amount is paid or disbursed by a German disbursing agent. No withholding tax will be imposed in special cases (for example, if a bank/credit institution holds the instrument).
A year has passed since the derivatives market was hit by the frustrating changes introduced in the legal regime for swaps by the 2008 State Budget Law. If the negative impact of the tax amendment in the derivatives market was clearly anticipated, it became increasingly obvious as the international financial crisis evolved. In the existing climate of a global recession an amendment to the 2008 swap legal regime had become even more urgent. In fact, the Portuguese tax regime was not only against withholding tax trends in other European countries, but also in clear contradiction with the international economic climate.
More than ever before the "new old" derivatives tax treatment introduced by the 2009 State Budget Law is an extremely positive step and a relevant signal to the markets, particularly to the Portuguese derivatives market, which has its legal regime for swaps back in the right track and heading to the future.
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