ENCHANCING PORTUGUESE CORPORATE TAX REGIME

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1 December 2013 ENCHANCING PORTUGUESE CORPORATE TAX REGIME The Parliament has approved the Portuguese Corporate Income Tax Reform. This Reform, which follow largely the recommendations of the Reform Commission, is intended to modernize further the Portuguese corporate tax system and reflect and adjust the corporate tax system to changes in the global landscape. The Law is now pending publication on the Official Journal (which is set to occur early January) and its measures will apply as from 1 January Garrigues tax team looks into the main tax measures likely to affect corporate investors. 1. Gradual lowering of the CIT rate Portuguese CIT rate is reduced from 25% to 23%. A reduced 17% rate will apply to the first of taxable income for small-medium enterprises, based on the legal definition provided by EU Commission Recommendation 2003/361/EC. Depending on the municipality of the activities, a municipal surtax ( derrama municipal ) will continue to apply up to a maximum of 1.5% of the taxable profits. In addition, a state surtax ( derrama estadual ) will apply as follows: 3% on taxable profits exceeding 1.5 million; 5% on taxable profits exceeding 7.5 million; and 7% on taxable profits exceeding 35 million (this third level is new as from 1 January 2014). It is agreed that a further reduction of the CIT rate to 21% in 2015 will be subject to approval by a special committee designed to monitor the effects of the CIT Reform. This committee will analyze the reduction of the rate in 2016 to achieve a CIT rate between 17% and 19%. No express mention is made to the recommendation made by the Reform Commission of phasing out the surtaxes by It is important to highlight that the CIT reform also does not imply a reduction of the standard rate of 25% of the withholding tax levied on non-resident corporate entities deriving Portuguese source income (levied for example on dividends, interest or rental income when an exemption or reduced rate of a tax treaty is not applicable).

2 2. Enhancing participation exemption for inbound dividends and capital gains The CIT reform amends both exemption for dividends received by a Portuguese company and capital gains derived from the sale of shares by a Portuguese company. Until 2014, the participation exemption applied to dividends arising from shareholdings of at least 10% in Portuguese or EU/EEA countries held for an uninterrupted period of 1 year and the participation exemption on capital gains applies only to pure holding companies (so-called SGPS) and venture capital companies (SCR) provided certain holding period requirements are met. As from 1 January 2014, to qualify for the 100% exemption on dividends received by a Portuguese company the main criteria will be: (i) 5% of the share capital or voting rights of company distributing dividends; (ii) 2 year holding period (may be satisfied after the income is received); (iii) available for all shareholdings, including those in non-eu entities, except when derived from entities domiciled in blacklisted jurisdictions; and (iv) company distributing the dividends would be subject either to CIT, taxes listed in the EU parent subsidiary directive, or an tax comparable to the Portuguese CIT at a nominal rate, corresponding to at least 60% of the Portuguese CIT rate (i.e. 13.8%). The Law provides for anti-hybrid clause for inbound dividends to exclude exemption if the dividend payment was treated as a tax-deductible expense at the level of the foreign distributing entity. This amendment follows the latest suggestions of amendment to the EU Parent-Subsidiary Directive. The Law also provides for a reset of holding period on (inbound) transfers of residence; and (iii) switch-over clause on inbound dividends whereby a credit for the underlying tax will be applicable where one or more of the conditions for the participation exemption are not met. For capital gains derived from the sale of shares, the Law also provides for exemption of capital gains for participations above the 5% threshold held for more than 2 years in the same conditions of inbound dividends. The changes include revoking the specific tax measures for Portuguese holding companies regime (SGPS) and venture capital companies (SCR). The Law provides for a carve-out rule where the assets of the participation disposed consist of more than 50% of Portuguese real estate (except for properties assigned to an agricultural, industrial or commercial activities not related to leasing and property trading). In any case, this rule shall only apply to real estate property acquired by the entity being disposed after 1 January The Law also provides measures to extend the participation exemption rules for dividends and capital gains to permanent establishments of foreign entities operating in Portugal. 2

3 3. Withholding tax on outbound dividends and liquidation payments The Law also provides new requirements to qualify for an exemption on outbound dividends, which until 2014 were limited to EU/EEA and Swiss corporate shareholders. To qualify for the WHT exemption for outbound dividend payments, the main criteria will be: (i) 5% of the share capital or voting rights of the Portuguese company; (ii) 2 year holding period before distribution (may be satisfied after the income is paid but refund may be requested); (iii) available for shareholders resident in EU/EEA (excluding EEA which do not exchange tax information with Portugal) or any jurisdiction which Portugal has signed a tax treaty with exchange of information mechanism; and (iv) company receiving the dividends should be subject either to CIT, taxes listed in the EU parent subsidiary directive, or an tax comparable to the Portuguese CIT at a nominal rate, corresponding to at least 60% of the Portuguese rate (i.e. 13.8%). The Law also provides new rules with regards the qualification of the liquidation income in the hands of the shareholders, which according to the Law will be qualified as a capital gain in the hands of the shareholders. No changes are proposed to the domestic exemption for capital gains derived by nonresidents from the sale of Portuguese shares or other corporate rights and securities, which continues to be broadly exempt, unless when such gains relate directly or indirectly from shares in resident companies whose assets consist of more than 50% of Portuguese real estate property or are derived by non-residents domiciled in blacklisted jurisdictions. 4. Exemption method for foreign branch profits The CIT Reform includes an elective regime for exemption of foreign branch profits as a measure to ensure greater alignment between the taxation of foreign branches and foreign subsidiaries and increase competitiveness of Portuguese businesses investing abroad. The election (per jurisdiction) will be possible where the branch profits are subject to a tax comparable to the Portuguese CIT at a nominal rate corresponding to at least 60% of the Portuguese corporate tax rate (and excluding blacklisted jurisdictions). The corollary of exempting foreign profits from taxation is that foreign branch losses would no longer be relievable. Specific recapture or exceptions rules are also included for situations where losses of a foreign branch were prior to 2014 already offset against taxable profits in Portugal (with exemption being limited to the amount of losses utilized). The election for exemption is subject to a stand-still rule of three years. 3

4 5. Patent box for qualifying IP rights and intangible assets with unlimited-life The Patent Box provides a partial exemption (50%) from CIT for companies exploiting patented inventions and other innovations such as models and industrial designs protected by intellectual property (IP) rights registered as of January 1, The partial exemption applies to a proportion of the profits derived from both the licensing and sale of the qualifying IP rights. In addition, the 50% exemption applies on gross income, so costs incurred in the development of the qualifying IP rights remain fully deductible. The main requirements to apply the patent box are: (i) qualifying IP must be self-developed; (ii) licensee cannot be resident of a blacklisted jurisdiction; (iii) IP must be effectively used for business activities; (iv) if licensee is a related company, the IP cannot be used to create deductible expenses for the taxpayer. The Law provides that the acquisition cost incurred with certain intangible assets with unlimited-life (acquired after 1 January 2014) may be tax deductible at a 5% rate over 20 years. This rule will be applicable either to industrial property rights (such as brands) or goodwill acquired in a business combination that is registered or purchased as of 1 January Goodwill associated with share acquisitions and assets acquired in the framework of tax neutral transactions or from entities domiciled in blacklisted jurisdictions are excluded. 6. Extension of loss carry-forward period The CIT Reform proposes to extend to 12 years the carry-forward period for losses originated as from 1 January On the other hand, the offsettable losses will be limited now to 70% of the taxable profit of the year. The CIT Reform also lowers/relaxes the thresholds where an ownership change is deemed to occur for purposes of the anti-loss trafficking rules. 7. Review of the interest barrier rule The 2013 Budget Law enacted a major change by replacing the old thin-capitalization rules (2:1 debt-to-equity ratio only applicable to non-eu-resident lenders) by an interest barrier rule which limits the deductibility of net financial expenses to the higher of the following: (i) 3m; or (ii) 30% of EBITDA (operating profits before interest, taxes, depreciations and amortizations). This measure was coupled by an important phase-in provision according to which the EBITDA limit will be 70% in 2013, 60% in 2014, 50% in 2015, 40% in 2016 and only 30% as from 2017 onwards. The Law provides for: (i) reducing the first barrier to 1 million; (ii) tax adjustments to the calculation of the EBITDA (until now determined in accordance with Portuguese accounting rules) which amongst others will exclude from EBITDA calculation 4

5 income/interest expenses incurred for the acquisition of a qualifying participation or income/interest expenses attributable to a permanent establishment to which the option for exemption is applied; (iii) specific rules for thresholds to be calculated at the level of entities taxed as part of a tax group (as today the limits are computed at individual level). 8. Group taxation regime and reorganizations The Law provides for several changes to the group taxation regime and to the rules applicable to reorganizations that streamline the regime and facilitate the operation of groups. As for group taxation, the changes include: (i) reduction to 75% shareholding the threshold to apply for group taxation; (ii) extension of the regime to sandwich groups (where lower tier Portuguese entities held by a foreign entity held by a Portuguese entity); (iii) streamline of the compliance obligations of beginning, termination and modifications to the tax group. As for reorganizations, the CIT Reform provides for a review of the range of transactions to which the Portuguese tax neutrality regime applies (e.g., reverse mergers), tax rules for non-neutral reorganizations and clarification of several tax aspects, including the value of the participations held by shareholders of merged/demerged companies and elimination of the need of a pre-request to transfer losses in the framework of tax neutral reorganizations. The Law also provides for rules governing the transfer of tax benefits of the merged companies and carry forward of non-deductible net financing expenses or unused EBITDA in the framework of tax neutral reorganizations. 9. Exit tax on the transfer of residence The CIT Reform also provides amendments to the exit tax rules applicable to transfer of residence of Portuguese companies to other EU/EEA countries. Besides the possibility of immediate payment of CIT upon exit, the CIT Reform provides for an option for payment in five installments and an option for deferral until the year of effective disposal of the asset or transfer of residence to another jurisdiction. 10. Foreign tax credit The Law provides for rules limitation on the amount of a foreign tax credit on a percountry basis and a five-year carry forward period to offset excess foreign tax credits. 11. Simplification of tax obligations The Law also provides for several measures designed to simplify and harmonize several compliance obligations, including removal of several situations of pre-clearances with tax authorities. Simplification measures also include changes on the formalities for application of tax treaty benefits. As an alternative for the prior obligation to obtain specific RFI forms (treaty forms) duly certified by the tax authorities of the country of residence of the beneficiary of 5

6 the income, a certificate of residence, following specific criteria, issued by the Tax Authorities of the other Contracting State, will be sufficient for tax treaty entitlement (RFI forms will still need to be completed without certification). 12. Transfer pricing rules The CIT Reform increases the related party threshold from 10% to 20% and substitutes the wide economic dependence test for a more limited legal dependence test. Following the proposals on the exemption of foreign permanent establishment profits, the Law also extends the transfer pricing rules to include transactions between foreign permanent establishments and their Portuguese head office or other permanent establishments. In order to address a perceived lack of flexibility of the Advance Pricing Agreements procedures, the Law clarifies that the taxpayer may always elect for a unilateral or bilateral APA covering cross-border transactions. 13. Other changes The CIT Reform provides for further tax measures, including measures affecting: Clarification of tax deductibility of expenses and setting of minimum requirements for documents supporting deductible expenses for tax purposes; Harmonization of CIT rules with the new international accounting standards in force in Portugal since 2010 affecting, amongst others, deferred purchases, construction contracts, subsidies, depreciation and amortization of non-current assets, development projects and bad debts; Rules for capital gains and losses not falling within the participation exemption rules and express rules for determining the date of acquisition of shares in the framework of reorganizations; Increase of autonomous taxation is applied on expenses related to passenger vehicles (excluding electric vehicles); New rules covering payment on account and special payment on account of CIT; Withholding tax on benefits in kind to apply on the gross-up market value of the goods or rights at the date of transfer (i.e. including any tax element); Withholding tax exemption on domestic interest payments arising from intra-group loans (more than 1 year), commercial paper or bonds where the debtor company is a Portuguese company whose share capital is held by a Portuguese company for more than 10% directly for a period at least 1 year (or indirectly through other companies in which the recipient is in a dominant position); Mandatory maintenance of accounting records and supporting tax documentation for a period of 12 years (previously 10 years); and 6

7 CIT simplified regime for small and micro-entities with annual turnover not exceeding 200,000 and total assets not exceeding 500,000. Entities covered may opt to be taxed on deemed income determined on the basis of turnover/fees/amounts depending on industry and nature of taxpayer. ***** For more information or if you wish discuss in detail any issues related to this alert, please contact your local Garrigues professionals and follow our special webpage on the CIT Reform: Lisbon Office Fernando Castro Silva Tel fernando.castro.silva@garrigues.com Porto Office Miguel C. Reis Tel miguel.c.reis@garrigues.com Tiago Cassiano Neves Tel tiago.cassiano.neves@garrigues.com December Garrigues Portugal, S.L.P. - Sucursal, all rights reserved. This work may not be used, reproduced, distributed, publicly communicated or altered, in whole or in part, without the written permission of Garrigues Portugal, S.L.P. Sucursal. 7