Portugal's Capital Gains Tax Rules in Violation of EC Treaty, ECJ Rules by Tom O'Shea

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1 Portugal's Capital Gains Tax Rules in Violation of EC Treaty, ECJ Rules by Tom O'Shea The European Court of Justice recently issued a judgment in Erika Waltraud Ilse Hollmann v. Fazenda Pública (C-443/06), finding that Portugal's differing capital gains tax treatment of residents and nonresidents who transfer Portuguese immovable property violates the EC Treaty principle of free movement of capital. Date: Jan. 16, 2008 The European Court of Justice recently issued a judgment in Erika Waltraud Ilse Hollmann v. Fazenda Pública (C-443/06), finding that Portugal's differing capital gains tax treatment of residents and nonresidents who transfer Portuguese immovable property violates the EC Treaty principle of free movement of capital. Under Portugal's CGT regime, Portuguese residents benefited from a special 50 percent reduction of the tax base but were taxed on a progressive basis up to a rate of 42 percent, while nonresidents like Hollmann were taxed on their capital gains at a special flat rate of 25 percent. Hollmann argued that the different tax treatment was disadvantageous to her and, in particular, that it breached her rights under EU law. The European Court of Justice recently issued a judgment in Erika Waltraud Ilse Hollmann v. Fazenda Pública (C-443/06), finding that Portugal's differing capital gains tax treatment of residents and nonresidents who transfer Portuguese immovable property violates the EC Treaty principle of free movement of capital. (For the ECJ judgment, see Doc [PDF] or 2007 WTD ) Under Portugal's CGT regime, Portuguese residents benefited from a special 50 percent reduction of the tax base but were taxed on a progressive basis up to a rate of 42 percent, while nonresidents like Hollmann were taxed on their capital gains at a special flat rate of 25 percent. Hollmann argued that the different tax treatment was disadvantageous to her and, in particular, that it breached her rights under EU law. When the matter was appealed and came before Portugal's Supreme Administrative Court, it sought a preliminary ruling from the ECJ with regard to whether the Portuguese tax rules at issue infringed EC Treaty articles 12, 18, 39, 43, and 56. Which Freedom Applied?

2 Faced with numerous possibilities, the ECJ examined each freedom in turn. Regarding article 39 (free movement of workers) and article 43 (freedom of establishment), the Court noted that when Hollmann, a German resident, sold her immovable property in Portugal, it was not "with the aim of carrying out a professional activity" in another EU member state, or "with a view to establishing herself in a Member State other than Germany to carry out an economic activity." In relation to article 18 (on EU citizenship), the ECJ found no evidence to suggest that Hollmann sold her Portuguese property with the goal of exercising EU citizenship rights. Consequently, the Court concluded that Hollmann could not rely on article 18, 39, or 43. Next, the Court examined article 12 and reiterated that this general provision concerning nondiscrimination on grounds of nationality applies only to situations in which the EC Treaty establishes "no specific rules of non-discrimination." In the case at issue, the "liquidation of an investment in real property" constituted a capital movement, according to the Court. Consequently, the disputed Portuguese tax rules fell within the scope of article 56 and needed to be examined in relation to the free movement of capital. Restriction on the Free Movement of Capital The Court noted that under the Portuguese tax rules, only 50 percent of the capital gains realized by Portuguese residents on the disposal of Portuguese immovable property was taken into account, whereas the full amount was taken into account for nonresidents. That meant that nonresidents were taxed less favorably than residents in relation to capital gains on the same immovable property, making the transfer of capital "less attractive for non-residents by deterring them from making investments in immovable property in Portugal and... from carrying out transactions related to those investments such as selling immovable property." Consequently, the ECJ concluded that the differing treatment constituted a restriction on the free movement of capital, which required justification. Justification The Portuguese government put forward three main arguments: that the tax rules at issue -- featuring a 50 percent reduction in the basis of assessment for capital gains of residents -- were intended to prevent residents from being penalized because they were subject to a progressive tax rate; that the differing treatment was justified by the fact that residents and nonresidents were taxed at different rates, with nonresidents receiving a special flat rate of 25 percent; and that the differing treatment was justified by the need to maintain the coherence of the national tax system. The ECJ noted that the "taxation of capital gains... concerns only one of the

3 categories of income received by taxable persons, whether they are resident or nonresident; second, it concerns both categories of taxable persons; and third, the Member State in which the taxable income arises is the Republic of Portugal in both cases." In other words, that the capital gains income was included in the total income of residents for purposes of establishing the progressive tax rate was not relevant. It was the actual gain received from the disposal of immovable property in Portugal that mattered. In relation to a similar capital gain, the Portuguese tax rules always resulted in "heavier taxation" for nonresidents, even though the resident's income was subject to a higher progressive tax rate. Comparability The Court concluded that "objectively speaking," there was "no difference in situation capable of justifying the unequal tax treatment in respect of the taxation of capital gains between two categories of taxable persons. Consequently, Mrs. Hollmann's situation is comparable to that of a resident," and her tax treatment was less advantageous compared with the tax treatment of a resident because a higher tax burden was imposed on her in relation to the realization of capital gains. Need to Maintain Coherence of the National Tax System In line with its settled case law, the ECJ confirmed that "the need to maintain the coherence of a tax system can justify a restriction on the exercise of the fundamental freedoms," provided that a "direct link" is established "between the tax advantage concerned and the offsetting of that tax advantage by a particular levy." The Portuguese government argued that there was such a direct link between the 50 percent reduction in the tax base of capital gains for residents and the taxation of their total income at the progressive rate. That argument was rejected by the Court, which determined that there was no direct link, because the "tax advantage granted to residents... outweighs the consideration for that advantage, namely, the application of the progressive rate to the taxation of their income." Consequently, the restriction on the free movement of capital could not be justified "by the need to ensure the cohesion of the tax system." The Court's Conclusion The ECJ concluded that article 56 precluded rules such as the Portuguese CGT rules at issue, under which the capital gains derived by a nonresident were subjected to a greater tax burden than that imposed on a resident in a comparable situation. Analysis The Hollmann decision is very much like the Lenz case (C-315/02), which involved Austria's dividend taxation rules. In Lenz, a special half-rate tax advantage was available to Austrian residents who received dividends from Austrian resident companies, but not for dividend income received from companies resident in other EU member states. This had two significant effects: It deterred investment by Austrian residents in companies resident in other member states, and it discouraged

4 companies resident in member states other than Austria from obtaining capital in Austria. The Court noted that to "the extent that revenue from capital originating in another Member State receives less favourable tax treatment than revenue from capital of Austrian origin, the shares of companies established in other Member States are, for investors living in Austria, less attractive than the shares of companies established in that Member State." The ECJ went on to analyze the comparability between Austrian residents who invested in Austrian companies and those who invested in companies resident in other member states. It concluded that the situations were comparable, noting that in relation to "a tax rule designed to attenuate the effects of double taxation of the profits distributed by the company in which the investment is made, shareholders who are fully taxable in Austria and receive revenue from capital from a company established in another Member State are therefore in a situation comparable with that of shareholders who are likewise fully taxable in Austria but receive revenue from capital from a company established in Austria." Consequently, the Court found that the Austrian tax rules constituted a restriction on the free movement of capital. In relation to the Austrian government's justification of the need to ensure the cohesion of the tax system, the Court determined that "the aim pursued by the Austrian tax legislation, namely the attenuation of an instance of double taxation, would not be affected in any way if one were also to give the benefit of the Austrian tax legislation to persons deriving revenue from capital originating in another Member State. On the contrary, the fact of reserving the definitive tax rate of 25% and tax rate reduced by half solely for persons deriving revenue from capital of Austrian origin has the effect of increasing the disparity between the overall tax burden on the profits of Austrian companies and that on the profits of companies established in another Member State." (For the ECJ judgment in Lenz, see Doc [PDF] or 2004 WTD ) The Portuguese CGT rules in Hollmann constituted a similar obstacle to the free movement of capital, reserving the tax advantage for Portuguese residents realizing capital gains from immovable property situated in Portugal. The tax advantage in question is illustrated in the following table, which supposes that a resident and a nonresident both make 10,000 from the sale of a house in Portugal. Resident in Portugal Resident in Germany Total Capital Gain 10,000 10,000 Total Taxable Gain 50% of 10, % of 10,000 Taxable Income 5,000 10,000 Tax Rate of 10% Tax Rate of 20% Tax Rate of 25% 500 (tax) 1,000 (tax) 1,250 (tax) (A) 2,500 (tax) (B)

5 Tax Rate of 30% Tax Rate of 42% 1,500 (tax) 2,100 (tax) (C) As can be seen from (B) in the table, the tax payable by a nonresident on a capital gain of 10,000 made in Portugal is 2,500, which represents a tax rate of 25 percent on the total gain. A Portuguese resident making a similar capital gain of 10,000 pays only 1,250 (see (A) in the table) in tax if taxed at a progressive rate of 25 percent and, importantly, pays only 2,100 if taxed at the top rate of 42 percent (C) under Portugal's progressive tax rates. The outcome is that the nonresident deriving a capital gain similar to one derived by a Portuguese resident always pays more tax than the Portuguese resident in a comparable situation. Moreover, the Court made it clear that it was the "capital gain" income from the disposal of the Portuguese immovable property that had to be compared; the inclusion of the capital gain income in the total income of the Portuguese resident for purposes of applying the progressive rate was not relevant. That is in keeping with the concept of discrimination that applies to "similar situations." Commission v. Portugal (C-345/05) Hollmann represents another setback for Portugal's CGT regime. In an earlier infringement case from 2006, Commission v. Portugal, which concerned the granting of a CGT exemption on permanent residences, the ECJ dealt with problems similar to those encountered in Hollmann. In Commission v. Portugal, the Portuguese rules granted an exemption from CGT arising on the transfer of real property consisting of a permanent residence, subject to the condition that the gains realized were to be reinvested in the purchase of real property situated in Portuguese territory. The European Commission sought a declaration from the ECJ that those tax rules were incompatible with EU law, particularly the free movement of workers and the freedom of establishment. The Court observed that even though such tax rules did not prevent a person from leaving to take up employment or to establish themselves in another member state, the rules at issue were "likely to restrict the exercise of those rights by having, at the very least, a deterrent effect on taxable persons wishing to sell their real property in order to settle in a Member State other than the Portuguese Republic." That constituted a restriction of EC Treaty articles 39 and 43, which required justification, the Court concluded. The Portuguese government, as in Hollmann, argued that the rules were justified by the need to ensure the cohesion of the tax system and that there was a direct link between the tax advantage and the taxation of the real property. The Court disagreed, pointing out that reinvestment of the proceeds of a sale in a residence in another member state equally provided a permanent residence for a person who had previously resided in Portugal, and that such a residence replaced the one transferred even though it was not situated in Portugal. Moreover, the Court rejected the notion of a direct link, saying, "There can be no capital gains tax thereon in the future unless

6 such gains are realised. Also, as long as the person concerned purchases a new property as his residence in Portugal, he can always rely on the exemption." In other words, there was no direct link between the granting of the exemption and the future taxation of the residence because there might be no taxation in the future if the proceeds were reinvested in a residence. The Court therefore determined that the Portuguese CGT exemption rule was incompatible with EU law. (For the ECJ judgment in European Commission v. Portugal, see Doc [PDF] or 2006 WTD ) Interestingly, in Commission v. Sweden (C-104/06), the Court found that Swedish tax rules that granted a CGT exemption on the sale of a residence, but only on the condition that both the residence sold and the newly acquired residence were situated on Swedish territory, were incompatible with EC Treaty articles 39, 43, and 18. (For the ECJ judgment in Commission v. Sweden, see Doc [PDF] or 2007 WTD ) Tom O'Shea, lecturer in tax law, Centre for Commercial Law Studies, Queen Mary, University of London