In the wake of the European Commission’s proposal for a Directive aimed at tackling the debt-equity bias in the European Union (“EU”) (“DEBRA”), Portugal has changed its approach to this issue in order to align it with the Commission’s position.
This change comes as a surprise considering that, last November, ECOFIN suspended the analysis of DEBRA until other already announced proposals in the area of corporate taxation are put forward by the Commission (e.g., proposals that bring the BEFIT initiative to life).
Notwithstanding this, the 2023 Portuguese State Budget Law repealed existing tax regimes aimed at countering the debt-equity bias and introduced a new capitalization incentive – the Incentive to the Capitalization of Companies (“ICE”) – that serves the same purpose. Although inspired by DEBRA, these new rules differ from the European proposal in several key aspects.
The previous Portuguese approach
Until now, Portuguese law provided for two tax incentives aimed at encouraging the decision to finance through equity rather than through debt: (i) the Conventional Remuneration of Share Capital (“RCCS”); and (ii) the Deduction for Retained and Reinvested Earnings (“DLRR”).
On one hand, the RCCS regime allowed companies to deduct a notional interest of 7% on share capital increases of up to EUR 2,000,000, in the tax year of the increase and in the 5 following tax years. If these increases were reversed and the resulting capital reimbursed to the shareholders, the total deducted amount, increased by 15%, was included in the taxpayers’ tax basis in the year of the share capital reduction.
For companies benefiting from the RCCS, the threshold of the earnings stripping rules was also lower - 25% (instead of 30%) of their tax-adjusted EBITDA.
On the other hand, under the DLRR regime, SMEs were granted a Corporate Income Tax credit of up to 10% of earnings retained and reinvested in the acquisition of certain fixed tangible assets. The amount of retained earnings eligible for this benefit was capped at EUR 12,000,000, for each tax year.
A DEBRA-inspired paradigm shift
The ICE allows companies to deduct 4.5% (or 5% in the case of SMEs and Small Mid Cap companies) of eligible net equity increases each year. This allowance is subject to the higher of the following limits:
-EUR 2,000,000; or
-30% of the companies’ tax-adjusted EBITDA. The amount of the allowance exceeding this limit, however, may be carried forward for a period of 5 years.
Similarly to DEBRA (that states that the Directive does not apply to some financial undertakings), entities subject to the supervision of the Bank of Portugal or the Insurance and Pension Funds Supervision Authority, or branches in Portugal of credit institutions, other financial institutions, or insurance companies*are not covered by this regime. In addition, this incentive is also not applicable to companies whose (i) tax and social security obligations are not duly regularized, (ii) taxable profit is determined by indirect methods; and whose (iii) accounting has not been organized in accordance with the accounting standards in force.
For the purposes of this regime, the following equity increases are considered eligible: (i) cash contributions at the company’s incorporation or in the context of a share capital increase; (ii) share capital increases carried out through the conversion of credits into share capital; (iii) share premiums; and (iv) retained earnings, including those utilized to increase equity reserves or share capital.
Method of application
With regard to the application of the ICE, considering the option for a fixed nominal interest rate (“NIR”), Portugal adopted a simplified system of implementation that largely differs from the one set out in DEBRA. As matter of fact, although the deductible allowance is also determined by multiplying the NIR by the allowance base, the similarities stop there.
Under the Portuguese rules, the total equity allowance to be deducted will be annually determined as whole considering the sum of the net equity eligible increases recorded in each financial year and in the previous 9 years*, which constitutes the allowance base. The allowance base will be zero whenever this sum’s result is negative.
This system differs from the one proposed in DEBRA which requires the taxpayers to track each year’s increase or decrease in equity on an "individual baskets" approach, and determines the need for positive adjustment to the taxpayer's tax base whenever an equity decrease occurs.
Under the ICE rules, the following equity increases are not eligible: (i) cash contributions that are indirectly financed by eligible equity increases in another enterprise; (ii) cash contributions made by an associated enterprise which are financed through loans granted by the taxpayer themselves or by a third associated enterprise; and (iii) cash contributions made by an enterprise that is not a resident of a EU Member State, a State of the European Economic Area, or a State with which Portugal has entered into a Double Tax Treaty, a bilateral Tax Information Exchange Agreement (“TIEA”) or a multilateral TIEA.
It is worth noting that the Portuguese regime does not provide for a rule allowing the taxpayer to prove that the above-mentioned transactions were carried out for valid commercial reasons and do not lead to a double deduction situation.
Unlike DEBRA, the Portuguese regime does not further limit the deduction of interest, a fact that may result in a significant impact on Portugal’s tax revenues.
According to the phase-in rules adopted by the Portuguese legislature, these rules apply to eligible net equity increases occurring after January 1, 2023, including those resulting from accounting distributable profits regarding 2022 (that are not used under the RCCS)*.
* This aspect has recently been clarified by Law 20/2023, 17 may. In what regards the phase-in rules, previously the ICE regime referred (i) that in calculating net equity increases one should only consider the equity increases recorded in the 9 previous years; and (ii) that it only applied to net equity increases occurring after January 1, 2023. This wording gave rise to doubts about the applicability of this regime as from 2023, the year of its entry into force.