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The application of tax treaties to collective investment vehicles: The Portuguese case

The purpose of this article is to make a brief summary of the problems and issues regarding the application of conventions to avoid double taxation to collective investment vehicles, and then to summarize the solution recently (2015) adopted by the Portuguese legislator to address such issues in an efficient manner.

1. Collective Investment vehicles and tax treaties

The issue of whether a Collective Investment Vehicle ("CIV") can qualify to benefit from the protection that a convention to avoid double taxation (hereinafter "DTT") may confer to taxpayers is an old problem, that has been systematically analysed over the years. The issue arises from whether CIVs may qualify as a "person" for the legal purposes of the DTT, and whether they qualify as "residents" for the same purposes.

1.1. CIVs as "persons" for DTT purposes

For a CIV to qualify as a "person" under the definition of the DTT it must be construed as a legal person under the laws of its country of incorporation. Regardless of whether the CIV is a corporate entity (a company), a fund or a trust, it must be deemed a legally autonomous entity. This means that the CIV must be an autonomous centre of imputation of rights and obligations to qualify as a "person" for DTT purposes.

A simple autonomous estate, that does not have any legal rights nor obligations, even if collectively held, in principle will not qualify for treaty protection under the concept of "person" for DTT purposes. However, the tax treatment of such a situation by the internal laws of each signatory State is relevant. If the State where the autonomous estate exists qualifies such as a taxpayer for income tax purposes, then the autonomous estate will, in principal, qualify as a "person" for DTT purposes.

In conclusion, for a CIV to qualify as a "person" for DTT purposes, and regardless of the form under which it operates, it should be considered a taxpayer of the State in which it was incorporated and/or is domiciled.

1.2. CIVs as "residents" for DTT purposes

For a CIV to qualify as a "resident" under the definition of the DTT it must be construed as an entity that not only is a taxpayer of its State of residence (i.e. a "person" according to the DTT) but also an entity that is liable to tax because of its residence (place of effective management, incorporation, etc.). As regards CIVs, this is important to the extent that most jurisdictions have created tax regimes for CIVs that attempt to avoid double taxation by ensuring that either the CIV, or the investors in the CIV, are exempt from taxation.

In those cases where the CIV is not liable to tax or is totally exempt from taxation regarding its income (for example, because it is a fiscally transparent entity), and taxation only occurs at the level of the investors, it is arguable that the DTT should not apply to the CIV. Generally speaking, the investors will need to invoke DTT protection in their jurisdictions of residence (when applicable).

We note that some States adopt the position that if a CIV is liable to tax, but totally exempt, it may still qualify for DTT protection. However, a large number of States, including Portugal, do not share this view, as expressed in the commentaries to the OECD Model Tax Convention.

2. The (new) Portuguese Tax Regime for CIV

In January 2015, the Portuguese tax regime for CIVs was deeply revised with the aim of turning the regime more attractive to foreign investment in Portugal, and also to promote the application of savings in the Portuguese territory. The new regime entered into force on the 1st of July of 2015.

In this sense, bearing in mind such goals, the Portuguese taxation model was aligned with the regimes in force in most Member States of the European Union, evolving from a taxation system in the sphere of the CIV to an "exiting" tax system, without jeopardizing, nonetheless, the tax position of non-resident investor's in Portugal.

Portuguese CIV now benefit from a favourable tax treatment based on the principle that the holder of the units will have the same basic tax treatment than if it had invested directly in the assets held by the CIV. This is relevant, as Portuguese CIV are flexible in their legal form, as they can be either investment funds or corporate entities, both forms subject to the same tax regime.

For taxation purposes, CIVs are now similar to normal companies, as they are taxed, as a rule, on their profits and the taxable income is subject to the general corporate income tax rate. However, CIVs are tax exempted as regards specific types of income, namely investment income, rental income and capital gains (with exception made to income derived from entities resident for tax purposes in "tax haven" territories).

Thus, only a small part of the income generated by the CIV will be actually subject to tax. We note, however, that introducing the rule of being subject to tax (although with several exemptions), allows for the possibility of having such investment vehicles (regardless of the form they assume: funds of companies) being eligible for the application of the DTT.

By avoiding the possibility of Portuguese CIV can be considered transparent for tax purposes, the Portuguese tax legislator has avoided the possibility of them not qualifying for DTT purposes, which would make it necessary to disclose every participant of the vehicle in order to assess whether the DTT could be applicable in particular for each one of them.

This was one of the relevant issues addressed by the Portuguese authorities when changing the regime as it solved one of the biggest obstacles for foreign investors in Portuguese funds, especially when compared to other international vehicles of the same sort.

As reagrds the participants/holders of the participation units in Portuguese CIV, the rule now in force is the taxation «at exit». Although in abastract the rule is the same for investors resident and non-resident for tax purposes in Portugal, non-residents may benefit from a tax relief, although an exception is made as regards income paid by Real Estate CIV, where a flat tax rate of 10% is applicable, as better explained below.

2.1. Investors resident in Portugal for tax purposes

As regards Individuals (when the income is not obtained in the course of a commercial activity, where specific rules apply), income distributed by the CIVs and capital gains from the redemption of units/participations are subject to definitive withholding tax at the rate of 28%. Investor may opt to add that income/gains to the remaining income and subject it to taxation at the progressive rates. The positive balance between capital gains and capital losses realized in the tax year on the disposal of units/participations to a third party is taxed at the autonomous rate of 28%.

In what concerns corporate entities, income distributed by the CIV is subject to withholding tax at the rate of 25% (which is not final – it is a payment on account) and should be included in the taxable profit of the year. Gains arising from the redemption and/or the disposal of units/participations to a third party are not subject to withholding, being included in the taxable profit of the year.

2.2. Investors not resident in Portugal for tax purposes

Income distributed and gains arising from the redemption of units/participations of Real Estate CIV are subject to withholding tax, at a definitive rate of 10% – this rule is applicable both to individuals and companies. Any capital gain arising from the disposal of units/participations to a third party is subject to an autonomous taxation of 10%.

On the contrary, income distributed and gains arising from the redemption of units/participations in Securities CIV are tax exempted as regards non-resident investors. The regime has a clear intention to promote foreign investment by determining a very low tax cost when investing in Portugal through a CIV.

However, an aggravation of the tax rate is applicable when the entities are resident, for tax purposes, in a "Tax Haven" – 28% will be applicable to individuals and 25% to companies.

To be noted, nonetheless, that, income paid by Real Estate CIV (and subject to the abovementioned flat tax rate of 10%) is qualified as property income for domestic and DTT purposes. As a consequence, the provisions of the DTT regarding the distribution of dividends and capital gains derived from the sale of securities will not be applicable. Additionally, the Portuguese participation exemption regime, that might have been applicable in such a way as to exempt dividend distributions and capital gains from the sale of participations (if the Real Estate CIV were a corporate entity) will not apply.

2.3. Stamp Tax

A final remark on the new rule introduced as regards Stamp Tax on CIV. In return for the more favourable taxation regime regarding Portuguese CIV, a rule where Stamp Tax is due on the total net value of the assets under management was also introduced, to be paid by the management companies on behalf of the CIV.

For the purposes of determining the Stamp Duty due, the following rates shall apply on a quarterly basis:

- 0,0025% where the CIU invests exclusively in money market instruments and deposits;

- 0.125% in all other cases.

3. Interaction of the Portuguese CIV regime with DTT

As stated above, the tax regime applicable to CIV in Portugal (corporate or investment funds) implies that these entities are only exempt on specific categories of income. As such, they are not only liable to tax, but are actual taxpayers that are exposed to corporate income tax in Portugal. In this way, the Portuguese CIV regime is not only tax efficient, it works well with DTT.

This tax regime implies that Portuguese CIVs may qualify as both "persons" and "residents" for DTT purposes and, as such, are an interesting vehicle for investors interested in not only the Portuguese market, but also looking into vehicles that might be usable for international investments. Portugal is not only a member of the EU, but also currently has a broad network of DTTs, that cover 79 jurisdictions (although only 70 DTT are actually in force).

However, certain care should be taken, as special investment vehicle regimes available in Portugal, such as that applicable to risk capital investment funds, do establish a full exemption and, as such, are regimes that may be questioned from a DTT perspective. As such, it is always recommendable to consult a specialist to ensure that the most efficient form of investment is being made, and that issues will not arise in the medium/long term.