Revamped Portuguese Controlled Foreign Company Rules – First cannon-shot?

Back in 1995 Portuguese legislator introduced controlled foreign company (CFC) rules with the specific objective of preventing profit shifting though low taxed entities. Portugal CFC rules currently included in Article 66 of the Portuguese CIT Code are bound to be amended by the Law transposing the EU Anti-Tax Avoidance Directive ("ATAD") which is pending publication. Due to the importance of the imminent changes, it is perhaps a good timing to understand why, how and what this revamped CFC rules may mean for companies and for individual shareholders. 

Firstly, an important review what Article 7 and 8 of ATAD say about CFC rules.

Under the ATAD CFC rules, Portugal should treat non-resident entities and permanent establishments as CFCs under two main conditions:

• When a local taxpayer holds at least 50% (directly or through associated enterprises) of the voting rights, capital or profit entitlement; and
• The non-resident entity (the CFC) is subject to low taxation, which is basically defined as less than half of the effective tax rate of the parent company jurisdiction (i.e. Portugal).

In such case, under the ATAD, Portugal may then choose to apply the CFC taxation in one of two ways.

• Under the first option (so-called categorical approach), the residence jurisdiction (Portugal) would include in the tax base non-distributed income of the CFC from interest, royalties, dividends, financial leasing, insurance, banking and intra-group invoicing, except if the CFC carries on a substantive economic activity supported by staff, equipment, assets and premises. This approach provides then for optional carve-outs in respect of CFC entity qualification and for substantive economic activity in respect of third-country CFCs. Under this categorical approach, the attributed income has to be calculated according to the corporate tax law of the residence state (i.e. Portugal). Losses of the CFC entity may be subject to a carry-forward.
• Under the second option (so-called transaction-based approach), the residence jurisdiction (Portugal) would include non-distributed income arising from tax-driven non-genuine arrangements, which are to be assumed if the significant people functions relevant to the assets and risks of the CFC entity are carried out by the resident taxpayer. This approach provides then for optional carve-out for non-residents with profits up to €750,000 and non-trading income up to €75,000 or for profits that do not reach 10% of operating costs. Under the ATAD, the income attribution is applicable to amounts generated by assets and risks in respect of which the significant people functions are attributable to the resident taxpayer. The arm’s length principle is used to determine the income.

Under the ATAD, double taxation should be avoided by deducting CFC profits from taxable dividends that are subsequently distributed by the CFC entity to the taxpayer or from taxable capital gains from the later disposal of the CFC. Taxes paid by the CFC entity in its residence state are to be credited in the taxpayer’s residence state.

Under the ATAD, the CFC rules had to be implemented by 31 December 2018, but the fact that Portugal had already CFC rules in place plays a role in considering that Portugal is not transposing late this part of the Directive.

Secondly, it’s worth understanding what the proposed amendments to the CIT Code are about.

Portugal continues to apply a full inclusion or entity approach as regards the CFC rules instead of the more specific categorical approach. This is basically an all or nothing taxation of the profits of the qualifying CFC entity.

Several points should be highlighted, based on the new wording:

• The CFC rules will maintain the existing 25% threshold for CFC application rather than the 50% threshold suggested by the ATAD. The option to reduce the threshold to a 10% shareholding is eliminated with the new wording. In short, Portuguese CFC resident shareholders (corporate or individuals) may fall under the CFC provision when holding, directly, indirectly or by means of a fiduciary or an interposing agent, at least 25% of the shares, voting rights, profit rights or assets of the relevant non-resident entity. The participation of above 25% in a CFC may be held directly or indirectly together with any associated enterprises.
• For qualifying a CFC entity as low taxed, Portugal adopted an alternative condition. Either the profits of the CFC entity are effectively taxed lower than 50% of the corporate tax that would have been paid on the CFC’s profits under Portuguese tax rules; or the jurisdiction of the CFC entity is included in the Portuguese blacklist of low taxed jurisdictions.
• The CFC rules are deemed not applicable when the sum of the income coming from certain passive categories does not exceed 25% of the total of their income. This includes the items from the categorical approach, namely royalties or IP income, dividends and capital gains from shares, financial leasing, operations specific to banking activities, intra-group trading entity and interest or other financial income. If jointly or isolated any of such income is deemed to be more than 25% of the total income the CFC entity may not fall out from the income attribution.
• As regards the substance carve-out provided by the ATAD, Portugal does not apply the CFC rules if the taxpayer demonstrates that the establishment and operation of the entity (in EU/EEA jurisdictions) correspond to valid economic reasons and that the economic activity develops an agricultural, commercial, industrial or service activity, with recourse to personnel, equipment, assets and facilities.
• In line with the ATAD, if the rules are then applicable the CFC profits are to be attributed to the parent in proportion to the taxpayer’s participation in the CFC entity. Also in line with the ATAD, credit for tax paid by the CFC entity is provided. If the CFC is loss-making, the loss may be carried forward for five years and therefore offset against CFC income within that carry forward period. 
• CFC profits distributed to the parent should be excluded from the parent’s tax base if they have already been included under the CFC rules. Burden of proof is on the taxpayer. In addition, any capital gains on disposal of the parent’s participation in the CFC entity should be deducted against the realization value.

Having covered the background, what are then the key impacts from this implementation?

Looking back, several factors can be traced as motive for CFC rules not having been applied on a widespread basis or not leading to any significant case-law since their enactment back in 1995. The world has also evolved and the capabilities of tax administration dealing with these types of instruments are not the same today.

Portugal went further than required under the ATAD, in the sense that the CFC rules follow an entity rather than a tainted income approach. This option was taken even when the OECD recognizes that a “full-inclusion system” has adverse effects on competitiveness – both for the country that enacts it and for the country’s multinationals.

If the CFC entity qualifying passive gross income exceeds 25% of its total gross income threshold and this CFC entity also meets remaining conditions for constituting a CFC (control and being subject to low taxation either because of low effective tax or domicile in blacklisted jurisdiction), then the CFC’s net income, in its entirety, may be taxed in the hands of its Portuguese parent company. We may therefore see CFC rule being applicable in situations irrespective of whether the income/profits has been shifted to that company for tax avoidance purposes.

The exercise today is merely to identify 5 initial critical points where the potential application of these far-reaching CFC’s may need to be monitored.

1. The first aspect is the maintenance of the Portuguese blacklist as a condition for a low tax test of a CFC entity. The blacklist last amended by Ministerial Order No. 292/2011 (with 81 jurisdictions) is not adjusted to the current times and not in accordance with principles of low tax jurisdictions set out in domestic law. In addition, there is no delisting rule which automatically excludes a country or territory from the blacklist upon the entry into force of a tax treaty (which is a further disadvantage). Finally, Portugal has been ignoring the EU list of non-cooperative jurisdictions and this does not mean good prospect to a blind application of the CFC.
2. The second aspect which may provide a wave new CFC cases is the 50% lower effective corporate tax rate (in contrast with nominal rates of prior rules). The ATAD only mentions “corporate tax” and unfortunately the Portuguese transposition does not clearly eliminate the surtaxes from the equation. The progressive nature of Portuguese CIT may bring it in some cases to almost 31.5% (with 50% being 15,75%).
3. The third aspect which will require very careful interpretation and application is the substance carve-out, which should not be interpreted as shifting the burden of proof to the taxpayer. At no moment the ATAD allows this shifting of burden of proof and therefore by adding the words “taxpayer demonstrates” the Portuguese position is clearly excessive.
4. The fourth troublesome aspect deals with the fact that Portugal has not chosen to extend the carve-out to third countries. With a high CIT rate in Portugal coupled with a blacklist of more than 81 jurisdictions, it is easy to understand what this will mean in terms of easiness to fall within the CFC tentacles.
5. Finally, there were several problems on the prior legislation but one of them was definitely not the safe-harbor rules. The rule that provided that CFC rules would not apply if at least 75% of the CFC entity profits arise from commercial or services activity not directed predominantly at the Portuguese market is apparently eliminated.

All being said, it is unfortunate that Portugal chosen wider rules without an effective consultation. Doubts (and likely litigation) will be raised on whether the actual application of the CFC rules beyond wholly artificial arrangements may be regarded as an unjustified restriction on the free movement of capital (or domestic principles of ability to pay and proportionality). This rule may also be said to be another shot in the foot on the maintenance of Portuguese holding companies (and raise critical problems with foreign holdings). Another issue that gains a new importance is its application to resident individuals and NHR. A point I mentioned on an article covering the potential policy contradiction of applying exemption method on dividends to non-habitual residents and stringent CFC requires now careful consideration. Personally, nothing against CFC rules but such rules need to be targeted not a cannon-shot to all taxpayers.