Portugal
Diogo Ortigão Ramos and Bruno Aniceto da Silva
Cuatrecasas Gonçalves Pereira
Lisbon
Diogo Ortigão Ramos and Bruno Aniceto da Silva of Cuatrecasas, Goncalves Pereira suggest that foreign funds should challenge Portuguese tax rules on the ground of discrimination against EC law.
The volume of tax litigation has increased in Portugal in recent years. If that is due to a rise in tax inspections and corresponding additional tax assessments, it is also a result of a greater awareness by investors of the advantages of assertive tax litigation.
Probably the best example of this approach to tax litigation comes from the opportunities provided by European Community tax law and, in particular, by the verdicts on direct tax case law by the European Court of Justice (ECJ). This has led companies or individuals all over the EU to challenge tax burdens based on the alleged breaches by their national tax systems of EC law. In Portugal this has recently led EU corporate groups to challenge domestic withholding tax rules applicable to the outbound payment of dividends from their Portuguese shareholdings based on the ECJ ruling in the Denkavit II case C-170/05, of 14 December 2006 and confirmed by the Amurta (Case C-379/05, of 8 November 2007) judgement. This gave rise inclusively, as of January 1 2008, to an amendment of the Portuguese withholding tax rules applicable to outbound dividends' payments to put them in line with EC law.
After this, new opportunities have arisen for challenging Portuguese withholding taxation. Indeed, the Portuguese taxation of pension funds and investment funds also raises eyebrows over a potential discrimination that inhibits foreign investors from claiming refunds of taxes withheld in Portugal.
Fund options
Pension funds are gaining in importance as a complement to traditional public retirement schemes. In the case of investment funds they are attractive as an alternative to direct investments. In both cases the funds' structure is similar: a pool of capital gathered from several investors which in turn is used to invest in different assets (for example, portfolio and debt securities). Roughly speaking, three parties may be said to play the key role in this sort of structure: (i) the investors that put their capital, (ii) the funds, and (iii) the investments made by them. Under this simplified structure, two flows of income can be identified: the income that arises to the funds from the investments they make and on the other, the income that is paid by the funds to their investors.
From a tax policy perspective, the investment made through funds should be tax neutral (as per comparison with direct investments). Those results are achieved in most cases in domestic situations but not in cross-border ones.
Taxation of pension funds
Portuguese tax law provides for different tax rules for domestic and foreign pension funds which receive income arising from investments located in this country. The rules applicable to domestic pension funds are quite simple: they are exempt, meaning that the income paid to the funds is exempt from withholding tax and corporate income tax (CIT).
Differently, income paid to foreign pension funds are subject to the general withholding tax rates applicable to non-resident taxpayers or, whenever it is the case, to the reduced rates applicable to that income in accordance with the double tax conventions concluded by Portugal. Considering that, as a general rule, most EU member states exempt pension funds from CIT, the tax withheld in Portugal ends up becoming the final tax burden over such income as there is no possibility to get the refund of the tax withheld by the pension funds' home country. Therefore, the issue regarding the cross-border taxation of income derived by foreign pension funds arises from the different tax treatment provided to outbound payments that are sourced Portugal. The withholding tax exemption under Portuguese law only applies if the payments are made to pension funds which are incorporated in Portugal.
Based on this situation, the European Commission has decided to refer Portugal to the ECJ (IP/08/1817, 27 November 2008) because outbound payments made to foreign pension funds are subject to a dividend withholding tax in Portugal of 20% (or a reduced treaty rate if applicable).
Considering that payments made to foreign pension funds are subject to withholding tax in Portugal, its different treatment vis-à-vis domestic pension funds could be in breach of the EC fundamental freedoms, in particular the free movement of capital in article 56 of the EC Treaty as it is likely to dissuade foreign pension funds to invest in Portugal as a result of this difference of treatment.
Probably the significant issue when dealing with a restriction to an EC fundamental freedom before the ECJ refers to the comparability test to be made between domestic and cross-border situations. In fact, to come to a prohibited restriction it is necessary to demonstrate that both domestic and foreign EU pension funds may be considered to be in an objective comparable situation. An analysis of the relevant ECJ case-law seems to support this understanding. Notably, in its Stauffer (C-386/04, of 14 September 2006) and Persche (C-318/07, of 27 January 2009) cases, the ECJ analysed the comparability between resident and non-resident not-for-profit (charitable) organisations. In those cases the ECJ considered that if both resident and non-resident entities pursue the same interests, then they are in the same condition and should be granted an equal treatment. The ECJ followed a somehow functional approach meaning that as long as both a foreign and domestic entity pursue the same type of activity and have the same purpose they should be considered as being in a comparable situation and therefore be granted the same tax treatment. The reasoning expressed afterwards in Aberdeen case (C-303/07, of 18 June 2009) added further arguments in this regard.
Accordingly there are good reasons for foreign pension funds to claim for refunds of any amounts unlawfully withheld over the past four years. It seems indeed to be clear that the activity and purpose of a Portuguese or an EU pension fund is the same and therefore they should be considered in a comparable situation, meaning that the Portuguese tax rules which tax differently domestic and foreign pension funds are in breach of EC law.
It is even possible to foresee severe difficulties for the Portuguese government in finding good arguments to object to such refund claims, not only because of the reasoning stated in ECJ case law referred, but also taking into account other relevant ECJ jurisprudence which has not accepted as justifications for different tax treatment reasons such as the need to preserve the cohesion of tax system, the need to ensure the effectiveness of fiscal supervision or the reduction in tax revenue. In most of the cases, the ECJ's reasoning is to consider that any of those arguments constitutes an overriding reason in the public interest which may justify a measure which is in principle contrary to the fundamental freedoms.
A further argument can even be added to those referred to above: several other EU member states provide for a different treatment for income paid to foreign pension funds compared with domestic ones. In this regard the Dutch tax authorities already approved the requests filed by EU pension schemes for refunds of Dutch dividend withholding tax for the years up to and including 2006. Similarly, the French Conseil d'État considered, in its decision in the Unilever pensioenfonds case (Case No. 298108, 13 February 2008), that the French withholding tax charged over dividends distributed to Dutch pension funds was in breach of the free movement of capital principle in article 56 of the EC Treaty.
Taxation of investment funds
The tax regime for investment funds is more complex than the one applicable to pension funds. In a nutshell, Portuguese sourced dividends are subject to a 20% withholding tax, whether they are received by domestic or foreign investment funds. In turn, income paid by Portuguese investment funds is not subject to withholding tax in Portugal, whether the unit holder is resident in Portugal or abroad and or is an individual or a corporate entity.
Portuguese corporate investors (or permanent establishments of foreign entities) include such income in their taxable base which will then be subject to a 25% CIT rate (plus surcharge of up to 1.5%). However, the tax paid at the level of the fund is treated as an advance payment of the final tax due, being, therefore, creditable against the final taxation of the Portuguese resident corporate investor. This may inclusively give rise to a refund where, due to tax losses, no CIT is payable.
Additionally, a further issue should be considered: a Portuguese corporate investor will be entitled to a CIT exemption of 50% of income paid by the fund on dividends received from participations in Portuguese or EU companies (which qualify for the Parent Subsidiary Directive) giving rise to a final tax burden of 12.5%. The same regime is also applicable to Portuguese resident individuals, which receive earnings from participation's units (within the scope of their normal commercial activity) and for Portuguese resident individuals which, although outside of their normal activity, choose to include the fund's income in their global income received.
Both of these benefits are unavailable to foreign investors and therefore the tax paid represents the final tax liability over the income derived in Portugal. Remarkably, in this case the Portuguese tax regime requires, for those benefits to apply, both a Portuguese investment fund and a Portuguese investor. The bottom line as referred is that it seems that Portugal has implemented a regime aimed at benefiting domestic investors by assigning them a tax credit in the amount of the tax borne by the fund. In defence of the Portuguese position, one could argue that no purpose would exist in assigning a tax credit to a foreign investor which is already exempt. However, this argument is not entirely convincing, as 50% of the income received by domestic investors is not considered as taxable income and therefore is not subject to taxation. Thus, at least the corresponding half of the tax credit will act effectively as a payment by the Treasury originating a refund in the absence of tax debts from other income. Good arguments therefore exist for foreign investors to claim a refund for the amount of half of the tax withheld in Portugal at the level of the investment fund, proportionate to their participation in it.
The ECJ line of reasoning seems to support this view as the different tax treatment between domestic and cross-border investments is likely to dissuade foreign investors to invest in Portugal, therefore being in breach of EC law, in particular the free movement of capital in article 56 of the European Treaty.
Arguments available
Foreign investors have good arguments now to challenge Portuguese withholding taxes. For that purpose a refund request should be submitted before the Portuguese tax authorities for taxes withheld over the last four years. The likely denial of such refund will lead to judicial appeals which may end with a reference by tax courts to the ECJ.
Diogo Ortigao Ramos (dortigaoramos@gpcb.pt) and Bruno Aniceto da Silva (bruno.silva@gpcb.pt), Cuatrecasas,Goncalves Pereira, Lisbon