U.S. Citizens and Portuguese NHR Tax Regime - Saved by the Savings Clause

Portugal has been increasingly on the radar of U.S. citizens as one of the sought-after relocation jurisdictions because of moderate costs of living, sunny weather, friendly environment, and favorable tax benefits.

Portugal offers a 10-year Non-Habitual Resident (NHR) regime that includes an exemption on certain types of foreign source income. However, much of the outcome depends on the interaction of the U.S. tax regime with the Portuguese tax rules and many other complex issues in terms of timing, qualification and/or source.

Since the inception of the NHR tax regime, we have been advising U.S. citizens relocating to Portugal and have been confronted in a few cases with an incorrect interpretation of the NHR regime when it comes to foreign-sourced capital gains generated by U.S. citizens.

A recent Arbitration Court case has confirmed our interpretation that the NHR regime granting an exemption on foreign-sourced capital gains based on the domestic “may be taxed” test should be read in combination with the Savings Clause applicable to U.S. citizens under the 1996 tax treaty between U.S. and Portugal.

The Arbitration Case

A U.S. citizen was registered in Portugal as a NHR since 2015 and derived, in FY19, income that qualified as capital gains from French and U.S. sources from both redemption or sale of units of investment funds and sale of shares.

Upon filing the tax return in 2020, U.S. citizen was confronted with a tax assessment that applied the 28% flat rate on capital gains from French and U.S. sources.

U.S. citizen also submitted a U.S. tax return in which he reported the capital gains declared in Portugal. Dissatisfied with the tax due, U.S. citizen appealed for the annulment of the tax assessment with the Portuguese Arbitration Court, which decided in his favor in March 2022.

U.S. citizen argued that capital gains from French and U.S. sources should benefit from the NHR tax exemption as such income may be taxed abroad. Such conclusion is a direct effect of the Savings Clause as set out in Article 1(1), subparagraph b) of the Protocol to the tax treaty between U.S. and Portugal.

Portuguese tax authorities counter-argued that the reservation made by the U.S. via the Savings Clause should be interpreted in connection with Article 25(2) of the tax treaty dealing specifically with the double taxation relief mechanism, which sets that income that may be taxed by the U.S. solely by reason of citizenship shall be treated as having its source in Portugal to the extent necessary to avoid double taxation. The Portuguese tax authorities contended the Savings Clause would not conflict with Portugal having the taxing rights as the Residence State, leading to the NHR exemption not being applicable. The tax authorities further contended, specifically in regard to the French source gains, that the “may be tax” test is also not fulfilled because the tax treaty with France allocates exclusive taxing rights to Portugal in relation to capital gains from shares.

The Arbitration Court (in a 3 panel judge decision) stated its reasoning by interpreting the NHR exemption as a domestic unilateral provision to eliminate juridical double taxation via the exemption method, that only requires for a “possibility of taxation” – actual or merely potential – of the income in question in the other contracting state (when a tax treaty in place) or under OECD Model (if no tax treaty is in place). The Arbitration Court considered that the NHR regime is not a total exemption regime but merely a rule aimed at income being only taxed in one jurisdiction and not leading to a concurrent and cumulative taxation by several jurisdictions.

The Arbitration Court concluded that the existence of the Saving Clause that reserves the U.S.’s right to tax its nationals (citizens) “as if the Convention had not entered into force” is sufficiently linear to consider that, as regards U.S. source income, the “may be taxed” test for the exemption method is fulfilled.

The Arbitration Court concluded that the powers to tax U.S. - source capital gains are not exclusive for Portugal but concurrent powers and therefore the condition for the exemption was fulfilled. It also noted that the U.S.’s ability to tax was not hypothetical and had a real expression on the tax return filed in the U.S., resulting in actual capital gains taxation.

Regarding French-sourced capital gains, the Arbitration Court recognized that the solution is less direct when compared to U.S. source income but reached the same conclusion. The Arbitration Court identified three jurisdictions with connecting factors: country of residence (Portugal), country of source (France) and country of nationality (U.S.).

Since the NHR exemption method establishes the domestic condition “may be taxed in the other Contracting State” (without limiting this to source), the nationality criterion is equally relevant for that “may be tax” test to be fulfilled in a triangular case. The Arbitration Court concluded that the NHR exemption is applicable to French-source capital gains because they were subject to tax in the “other State, as the U.S. retained worldwide taxing rights towards U.S. citizens.

Our Take

In simplified terms, the Portuguese Arbitration Court recognized that because a U.S. citizen must include worldwide capital gains in their U.S. taxable income, and U.S. taxation is preserved by a treaty-based rule, that the conditions for a Portuguese domestic exemption for foreign sources capital gains are fulfilled, and those capital gains are therefore not taxable in Portugal.

The outcome of the case marks a very positive result for U.S. citizens under the NHR regime with foreign capital gains. Albeit there is no rule of precedence in Portugal, this still provides a good indication of the outcome of future disputes.

The fact that we face a decision by an Arbitration Court instead of Judicial Courts has no bearing on the pertinence of this decision. Portugal adopted an Arbitration regime to settle tax disputes back in 2011 to counter lengthier times in ordinary courts, with decisions being taken by a panel of three reputable judges or one single judge (depending on the value). With few exceptions covering contradictory decisions or constitutionality issues, there is no possibility to appeal against an Arbitration Court decision.  This means that at this stage this decision appears to be final.

Regardless of the outcome, U.S. citizens that have relocated to Portugal under the NHR or that are considering relocating to Portugal should carefully revise their wealth structures from a U.S. and Portuguese standpoint to adjust to the ever-changing tax rules or decisions on both jurisdictions.

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© Kore Partners, 2022

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