Portuguese Controlled Foreign Companies rule and individual shareholders
Back in 1995 Portuguese legislator introduced controlled foreign company (CFC) rules with the specific objective of preventing profit shifting though low taxed entities.
Currently set out in the Portuguese Corporate Tax Code, these rules also apply to individual shareholders and were amended as a result of the EU Anti-Tax Avoidance Directive ("ATAD"). Due to the importance of the subject, it is always timely to understand why, how and what these revamped CFC rules may mean for individual shareholders.
In a very simplified manner, the rules are triggered by the following:
Rule No. 1 (personal scope of application): The CFC rule applies to tax resident individuals holding, directly or indirectly, at least 25% of the shares or voting rights of non-resident entities. This includes shareholdings held through an agent, trustee or interposed person, although in foreign trust cases of the Portuguese resident individual it may be understood as requiring certain control over the income.
Rule No. 2 (entities in black-listed territories): The CFC rule applies to entities non-resident for tax purposes in Portugal and domiciled in jurisdiction deemed as blacklisted in Portugal, please see the list (as amended recently with the exclusion of Andorra).
Rule No. 3 (low-taxed entities): Besides entities in blacklisted territories, the CFC rule also applies to non-resident entities subject to effective taxation on profits lower than 50% (i.e.10.5%) of the CIT tax that would be due in Portugal.
Rule No. 4 (exception for non-passive activities): The CFC rule does not apply – even if the above rules are fulfilled – if the passive income of the CFC entity does not exceed 25% of its total income. From the 6 types of passive income covered by the CFC rules, the most common applicable to on CFC corporate structures are: (i) royalties or IP income; (ii) dividends and capital gains; (iii) income from financial transactions and leasing; and intra-group billing/invoicing entities.
Rule No. 5 (exception for valid economic reasons): The CFC rules do not apply when the entity is resident for tax purposes in another Member State of the EU and the taxpayer (in this case the Portuguese tax resident individual shareholder) demonstrates that the setting-up and operation of the entity corresponds to valid economic reasons and that it carries out an economic activity of an agricultural, commercial, industrial or service nature, using human resources, equipment, assets and facilities. This exception may depend on the substance and timings adopted by the CFC entity and discussion may arise if the burden of proof rests with the taxpayer.
The rules above may bring one of the two possibilities: (i) If some of the exceptions are met then the CFC rule does not apply at the level of the individual shareholder; or (ii) If the exceptions are not met then the next rules need to be followed to determine the consequences of applying the CFC rule.
Rule No 6 (practical application of the CFC rule): Assuming that the conditions to apply the CFC would be met, the undistributed profits of the CFC shall be attributed to the Portuguese tax resident individual shareholder being applicable the rules foreseen in the CIT Code duly adapted to specificities of personal income taxation. The profits from the fiscal period of the entity shall be allocated according to the proportion of shareholding (deducted from income tax on these profits that were paid in the entity state of residence). The tax rate of 28% or 35% would in theory apply to this attribution of income.
Rule No 7 (distributions): When the individual shareholder tax resident in Portugal, receives the distributed profits of the CFC, those amounts which have already been allocated for the purposes of Rule No 6 in respect of previous tax periods are deducted from the taxable amount.
Rule No. 8 (interaction with the NHR regime): Under the NHR regime, the dividends received from a company resident for tax purposes in CFC are exempt from taxation in Portugal for 10 years. The Portuguese tax law does not expressly tackle how the CFC rules are (or not) applicable to NHR individuals. In our view, there could be arguments to consider that in cases where the CFC is not deemed tainted income for a NHR perspective (i.e. does not derive directly or indirectly from income to which the exemption rule would not be applicable) the application of the CFC rule could be considered inconsistent with the exemption of dividends. Indeed, there is no clear mechanism on reverse a CFC imputation for an NHR.
The reengineering of CFCs rules post ATAD add further complexity and running a CFC analysis is critical from a Portuguese perspective, including for qualifying individual shareholders.
© 2021 Kore Partners.