Tainted income and a box of surprises

In tax there are many names given to the same thing. Tainted income basically refers to “bad income” or income derived from certain low tax jurisdictions – the so-called tax havens that are commonly referred to “blacklisted” jurisdictions in opposition to “whitelisted” jurisdictions. Perhaps more politically correct in these days is to refer to this as “tainted income”.

The actual taxation of tainted income in Portugal and the non-application in certain cases of the NHR exemption is involved in considerable debate and in the briefing, we will delve into some of the key points.

Now that we know that tainted income is income sourced in a listed jurisdiction it is time to identify the surprises on tax toolbox.

Here comes the first surprise. Portugal has its own national list for almost 20 years and it has nothing to do with the EU list of non-cooperative jurisdictions for tax purposes (updated in February 2021). You may compare both lists here. The national list is much wider and apart from the recent exclusion of Andorra from the list with effects as from 1 January 2021 it has maintained itself almost unalterable in the last years. In essence, Portugal ignores the EU list.

The second surprise is that there is no automatic delisting rule which automatically excludes a country or territory from the list upon the entry into force of a double tax treaty. This is rather awkward but yes it may happen to have listed jurisdiction with a tax treaty in Portugal. The same non-delisting applies to jurisdictions with a Tax Information Exchange Agreement (TIEA) in force with Portugal. In times where there is automatic exchange of information mechanism in place, one could even question the justification for such discrimination towards certain jurisdictions.

Moving forward, the third surprise is that there is myriad of provisions on Portuguese tax laws referring to the list of jurisdictions (we counted more than 40 domestic law provisions). For personal income tax purposes, the list may be relevant, for example, to determine the:

• Application of trailing tax or extended tax liability for 5 years for Portuguese nationals transferring their tax residence to such listed jurisdictions.

• Exposure of CFC rules that may result in profits of a listed entity being directly taxed in the hands of individuals who hold, directly or indirectly, even when through a nominee, trustee or third party, at least 25% of the share capital, voting rights or rights to the income of those listed CFC entities.

• Disregarding capital losses derived from transactions in which the counterparty is resident in a listed jurisdiction which then may not be offset against other capital gains.

• Levy of 35% tax rate (instead of exemption or standard 28% rate) on certain income derived by resident individuals, namely: (i) investment income paid by entities resident in listed jurisdiction; (ii) repayment of bonds or debt securities and redemption of fund units from entities resident in listed jurisdiction; and (iii) gains from liquidation of fiduciary structures by the settlor domiciled in listed jurisdictions.

Ok enough of surprises. Let’s delve into some practical situations that resident and NHR encounter in Portugal.

Case 1 – Taxpayer derived €100 of interest from a bond of an international group but that bond was issued via a Guernsey entity.

Outcome: The ISIN (alpha-numerical code) will identify the issuer of the bond. If that issuer is legally domiciled in one of the jurisdictions on the Portuguese list and that jurisdiction does not have a tax treaty in place with Portugal, the €100 interest should be taxable at a 35% rate. Even if we know that such bonds are issued in such jurisdictions for non-tax reasons (mostly regulatory reasons), the Portuguese tax rule simply deems this as abuse and taxes at highest penalty rate.

Case 2 – Taxpayer derives a loss of €100 from equity position on a publicly traded entity on the HK Stock Exchange and also domiciled in HK and realizes a €200 gain from a mutual fund publicly traded and domiciled in Dubai

Outcome: Economically the taxpayer only derived €100 of capital gains that if taxable at standard rate 28% would lead to a tax of €28. Now, the interaction of the tax reporting where the taxpayer included the source as being in a listed jurisdiction may lead based on prior experiences to disregard the €100 of loss and to tax the €200 gain at 35%. This would be equivalent to a 70% effective tax rate. Naturally, one could argue that the counterparty of this transaction is unknown (as the transaction is made on a public stock exchange) or that the outcome leads to an unjustified discrimination of foreign investment.

Case 3 – Taxpayer derives €100 income from the redemption of units of a mutual fund domiciled in Cayman and €100 gains from the sale of shares from a company based in Uruguay

Outcome: Economically the taxpayer derived €200 of capital gains but as the redemption of the units will be taxed at 35% but the gains from the shares remain taxable at 28%, the final effective combined rate will be 31.5%. The fact that the 35% applies only to repayment of bonds or debt securities and redemption of fund units and not sale of shares remains in our view unexplained.

Case 4 – Taxpayer has a 30% participation in a company located in a listed jurisdiction considered covered by the CFC rules and not excluded by any carve-out. That entity derives €333 of profit which is reinvested in the business activity.

Outcome: If the CFC rule would apply the taxpayer could be exposed to pay tax at 35% on €100 of presumed profit regardless of any actual distribution. Let’s assume for example that the 70% shareholder is non-resident and has a policy of not distributing any profits. Theoretically, the taxpayer could be exposed with a tax bill without having cashed (dividends) to pay the tax. One could possibly even argue that such shareholder has no ability-to-pay out of those (fictional) profits.

Case 5 – Taxpayer qualifies as an NHR and derives dividend income from a company operating and taxed in Panama.

Outcome: Even if the income is derived from a listed jurisdiction, Panamá has a tax treaty in force with Portugal. Hence, the dividends may be taxed in Panamá under the tax treaty and therefore the income should be exempt under the NHR regime.

 Bottomline, we have learned that when it comes to tainted income the outcome can be rather negative and international tax expertise will be required to navigate the complexities. 

 No wonder, Albert Einstein once said, “the hardest thing in the world to understand is the Income Tax”.

Key takeaways

1. Examine carefully the financial portfolio;

2. Evaluate the types of income derived and the source of the underlying income;

3. Be attentive to domestic rules and reporting as outcomes may be severe;

4. Legal challenges to severe outcomes remain untested; and

5. Recognize that other solutions are available to maintain investment flexibility.

Download the Private Client Briefing

© Kore Partners, 2021

This briefing provides for general information and is not intended to be an exhaustive statement of the law. Although we have taken care over the information, this should not replace legal advice tailored to your specific circumstances. This briefing is intended for the use of Kore Partners clients and is also made available to other selected recipients. Queries or comments regarding this including joining our mailing list can be directed to kore@korepartners.com