RETT in Portuguese Share Deals - Much Ado About Nothing

The Portuguese Budget Law for 2021 was approved in Parliament and although the final text is not yet available, it is important to delve into one controversial proposal that startled the real estate sector and was amended in the final stretch of discussions.

The change included in the initial draft indicated an intention of the Government to equalize the taxation of real estate transfer tax (RETT) between type of entities and this alarmed a sector very much used to share deals without VAT, Stamp Tax or RETT impacts at the level of the purchasers.

Historically, only the acquisition of quotas of a limited company - Lda type (not qualifying as a corporation or S.A.) - that owns immovable property would be liable to the payment of RETT at a 6.5% rate when, by such acquisition, one of the shareholders becomes the owner of a participation of at least 75% of the equity of the company. In such cases, RETT would then be applicable over the cadastral tax value or balance sheet value, whichever higher (in proportion of the shareholding above 75% acquired).

Indeed the fact that other corporate types of entities (such as an S.A.) would fall outside the scope of such provision led to the widespread use of this type of entities in real estate investments.

This rule dated from 1959 is clearly outdated as it was drafted with a very particular target of preventing shielding family properties within this type of companies and transferring the shares. At that time, one may say the drivers of tax minimization were closely-held family entities and the wave of foreign real estate investment was very far away.

Truth to be told that the RETT rule stood the test of times until 2020 and remained with a very formalistic wording that even tolerated two different corporate purchasers acquiring separately 74% and 26% share capital of the Lda without formally triggering the RETT.

Being this RETT a cost for any purchaser of shares and thereby impacting directly on pricing, another form of side-stepping the application of this rule was to undertake a corporate conversion to an S.A legal form.

But the world changed dramatically and with globalization came the focus on different types of real estate investment, from offices, retail, hotels, industrial, logistics to residential. The numbers reached in 2019 a staggering €3.2 billion in Portuguese commercial property transactions (excluding residential segment). Many of those transactions were undertaken through share deals.

It was not only the sophistication of the investors or the size of the ticket of the transactions that increased but also the scrutiny of tax authorities towards large transactions and the emergence of a general anti-abuse clause that with its subjectivity served as a major deterrent to certain type of tax driven transactions.

With such context it is normal that the real estate being wary of any changes being made to RETT on share deals as there is always the risk that when the “patient” goes to the surgery room it comes out in worse shape. 

Fortunately, the final proposal approved equalized the RETT treatment between different corporate legal forms but at the same time limited the scope of such rule to limited cases.

Under the new rule set to apply as from 1 January 2021, to trigger RETT at 6.5% rate in a share deal it is necessary that the following tests are cumulatively met:

• Value Test – real estate asset value of the company transferred is, directly or indirectly, composed by more than 50% of real estate assets located in Portugal (being such value based either on the balance sheet value or cadastral tax value, whichever higher). REITs or companies with shares admitted to trading on a qualifying regulated market are excluded; and
• Asset Test – real estate assets are excluded when directly allocated to an activity of agricultural, industrial or commercial nature, unless the activity is of purchase and sale of real estate property (i.e. property trading); and
• Shareholding Test – as result of the acquisition (or other corporate events) one of the shareholders retains at least 75% of the share capital of the target entity (or the number of shareholders is reduced to two persons married or in a de facto union).

The application of the 3 cumulative tests for RETT in share deals is good news to the real estate investors even if some blind spots are left outstanding and deserve further maturing.

On the value test, it is likely such test is met in most share deal transactions, as it is standard to isolate key real estate assets in property owning companies. In any case, in certain type of restructurings the rule is positive because it no longer requires applying a specific tax incentive available for corporate restructurings when the value of real estate falls below other assets.

On the asset test, one is immediately reminded that the language is indistinguishable from the one used for the participation exemption for capital gains derived from the sale of 10% stake on a Portuguese company holding real estate. This language interchangeability leads to consider the two points:

1. On a recent tax ruling, the tax authorities addressed the case of the disposal of a company owning a property (hotel), under financial leasing, which is allocated through a rental agreement to a hotel activity. In that instance, it was concluded that since (i) the property was registered as property, plant and equipment (IAS 16) and (ii) the company did not have the object and purpose of buying and selling properties – that this was sufficient to be considered an activity of commercial nature and not of property trading.
2. For entities that undertake mere rental activity of real estate assets there is settled case-law from Portuguese Supreme Court which may be used to consider that this remains a commercial activity as the Court indicates that "as long as there is an increase in value for the property due to the exercise of an economic activity (even if expressed in a single act) translated into the creation of an economic benefit (…) in which the assets of entity are increased, there will be a commercial activity”.

On the shareholding test, the legislator seems not to have learned from 60 years of the prior RETT rule and maintains within the scope for acquisition by one shareholder acquiring 75% or more of the target entity. The tax system is full of specific anti-abuse rules targeting entities that qualify as related parties for transfer pricing purposes and this is not the case with this new provision. The absence of such rule thereby leaves to the Courts to validate to what extent transactions that fall short of the 75% test may still be challenged via the GAAR. 

As this rule applies equally to Lda and to S.A. the immediate consequence will be that real estate investors will be shifting back to the use of Lda since corporate wise Lda is an easier vehicle to manage.

Bottom line, this tax discussion was akin to a Much Ado About Nothing where the investors seem to have gotten the win on this first round. Yes, I expect a second round some years down the road….

Post-Scriptum: Hat Off to Ricardo Palma Borges (see comments) for pointing this lateral but relevant issue. Within the approved Budget rules there is also a separate rule providing a 10% RETT rate (with no exemption or reduction being applied) whenever the entity acquiring Portuguese property is an entity dominated or controlled, directly or indirectly, by an entity with tax residence in a jurisdiction included on the extensive Portuguese blacklist. For this purposes, a relationship of “dominating influence” is for example presumed to exist when the blacklisted company holds (directly or indirectly) the majority of capital or the voting rights of the Portuguese company (following principles of Article 486 of the Portuguese Companies Code). The outreach of such provision raises many questions and this short piece is not the right place to address those. Anyway questions may be raised if this defensive measure is in line with the EU freedom of capital (specially on the part it focuses on intermediate shareholders but not on the ultimate beneficial owner that may reside in a non-blacklisted jurisdiction). 

5 December 2020

Tiago Cassiano Neves