SICAV Distributions - Winds of Change?
Ruling 755/2018 published in May 2022 deals with the tax framework for income paid by SICAV derived by taxpayers with NHR status. This ruling potentially indicates a shift by the Portuguese tax authorities on the qualification of income and therefore may have implications for certain type of investors and in some cases could lead to litigation. The following summarizes what is at stake:
Why the tax ruling was requested: The ruling was requested by a Portuguese based financial company responsible for the marketing and distribution in Portugal of a Foreign SICAV, a fund in corporate form with variable capital (UCITS V type) that is domiciled in Luxembourg. This ruling was requested because when income obtained by residents in Portuguese territory, arising from holdings in investment funds domiciled abroad is paid in Portugal there are situations where withholding tax in Portugal needs to be levied, namely when the payment is made available by local financial intermediary acting on behalf of the foreign fund. As NHR regime provides in certain cases tax exemption, the Portuguese payor considered was necessary to clarify the scope of the withholding tax exemption that applies when income falls within the NHR exemption method.
How is income of funds generally taxed in Portugal: Portuguese income tax distinguish between (i) distributions of profit, which have the nature of investment income and are generally taxed at 28% when received; and (ii) income from redemption, transfers for consideration and liquidation, which are qualified as capital gains and give rise generally to a taxation of 28% on the positive difference between the acquisition cost and the sale or proceeds received.
How is an NHR taxed in Portugal on foreign income from capital invested: An NHR benefits from an exemption on foreign source income to the extent that such income “may be taxed” in the source country under the distributive rules of the double tax treaty between Portugal and the source country (or the OECD Model in case a tax treaty is not in place). This means that to determine the application of a tax treaty, an analysis needs to be made on: (i) type of income received; (ii) determine the source of the income; (iii) determine if a tax treaty is in place which distributive rule applies. It is generally the case under tax treaties that dividends may be taxed by the source country, whilst capital gains are only taxable in the recipient residence country. Some tax treaties may provide different outcomes (e.g. tax treaty with Brazil).
How is the position of NHR as regards income from funds: Taking into account the bifurcation under Portuguese tax law of income from distributions (investment income) and income from redemptions (capital gains) and the fact that to apply for exemption on NHR foreign income it is necessary for the income received to fulfil a “may be taxed” condition, it was the understanding of the industry that one should distinguish between corporate and non-corporate funds (as only corporate funds may have distributions from a corporate entity). In addition, another understanding of the industry was that one should distinguish between accumulating corporate funds (where the investors exit by redeeming shares) and distributing type corporate funds (where the investor receives an income that may be assimilated to a profit distribution of the entity). The understanding being that under certain tax treaties, these corporate funds structured as distribution-type funds would qualify as corporate entities resident in their place of residence (source of the income) and therefore the income would qualify as dividends when paid to an NHR and hence fulfil the may be taxed condition of the NHR regime.
What were the disclosed positions of the tax authorities up to the 2022 ruling: In 2010, the Portuguese tax authorities releases a mutual agreement procedure on the interpretation of the Portuguese/Luxemburg tax treaty, whereby Portugal accepted that Luxemburg based SICAVs may be considered liable to tax for the purposes of Article 4 of the Portuguese/Luxemburg tax treaty. Later in 2020, the Portuguese tax authorities released a ruling covering a Swiss domiciled SICAV where the tax authorities considered that the distributed income paid by the SICAV was qualified as dividends under the Portuguese/Swiss tax treaty and therefore the income would thus qualify for the NHR exemption. These two precedents were indicative of the position that at least for corporate based funds distributions received from an NHR, the exemption method should apply.
What were the arguments used for this new ruling: The tax authorities stated that is not unequivocal that income distributed from investment funds should be included in the concept of dividends under Article 10 of the Luxemburg/Portugal tax treaty. The tax authorities referred to the OECD Model Commentary to Article 10 which qualify as “dividends” the distribution of profits to shareholders by legal entities with a separate juridical personality distinct from all their shareholders. The ruling refers to Paragraph 23 of the Commentary that mentions “great differences between the laws of OECD member countries” to argue “that it is impossible to define dividends fully and exhaustively”. The ruling also refers to Paragraph 24 that highlights that the “notion of dividends basically concerns distributions by companies within the meaning of Article 3 (i.e. any body corporate or any entity treated as a body corporate for tax purposes). Surprisingly, the ruling extracts from OECD Model Commentary sufficient basis to justify an apparent absence of uniform definition of dividends. This impacts on qualification that remains at the discretion of the treaty countries and that such countries should agree in bilateral negotiations the extension of the concept of dividends to other payments made by SICAVs. The ruling then concludes that this ultimately results in income distributed by a SICAV in Luxemburg falling within Article 22 of the tax treaty (the so-called other income article), which allocates to the taxpayer residence the exclusive right of taxation, such as in the case of capital gains.
What it means the outcome of the new ruling for NHR residents: The outcome of the ruling is that distributions from Luxemburg-based investment funds, even if apparently set-up as corporate form such as a SICAV, may be considered as “other income” within Article 22 of tax treaty and therefore application of the exemption method could be excluded, and income taxed at the 28% rate. The ruling also addresses the income arising from redemption, disposal or liquidation of funds as qualifying as capital gains under Article 13 and concluding that for such income derived by an NHR also the exemption method is excluded and the net income taxed at 28% rate.
Which are the shortcomings of this ruling: We identify at least five shortcomings:
The first is uncertainty created because a ruling provides an indication of a new position of the tax authorities on a particular matter and tax authorities are expected to follow the position of the ruling (i.e. in future inspections or tax assessments).
The second shortcoming is the conflict between two rulings on the same subject, since the Portuguese law does not directly address the situation of rulings issued months apart by different departments of the tax authorities having conflicting positions.
The third is technical because the argumentation used by the tax authorities and the actual references to the OECD Model Commentary seem to be inaccurate.
The fourth is that this ruling may be said to simply ignore the relevance of the 2010 agreement on standardizing the interpretation of the tax treaty to the framework of the Luxembourg SICAVs.
The last shortcoming is whether such reasoning may indicate a shift in tax policy and application of the NHR regime by the Portuguese tax authorities providing ingenious interpretations that prevent taxpayers from lawfully benefiting from the exemption method on distributions that Portuguese law provides for NHRs.
What should be the next steps: NHR taxpayers that receive distributions from Luxemburg SICAVs or any other corporate funds established in jurisdictions with a tax treaty in Portugal should discuss with their legal advisor on the available tools to dispute any wrongful interpretation of the NHR regime and tax treaties that may have the consequence of eliminating the exemption method. We consider that each case is a case and there may be material differences between jurisdictions and tax treaties with Portugal, so an international tax expert may be necessary to guide taxpayers on those potential variations.
Ultimately, we also believe that if the tax authorities are not pleased with the outcome of exemption for 10 years for dividends they should change the law and not attempt to change the interpretation of a law via ruling on a matter that has long been assimilated by taxpayers that the NHR exemption would apply.
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