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Tax Competition in Europe

Portuguese Report

Patrícia Noiret Cunha*

I. General Aspects of the domestic tax situation

1. The notion of “tax competition” in domestic legal and economic science

2. The political attitude of the government towards tax competition

II. Elements of tax competition in the domestic tax system

1. Tax rates (low or no effective tax rates, either general or specific for foreign

investment)

2. Tax accounting (general or specific for foreign investment, e.g. artificial

definition of the tax base, tax deferral etc.)

3. Double taxation relief (inbound and outbound) and other advantages for cross-

border-business (e.g. no exchange of information, transfer pricing)

4. Procedural advantages (rulings, tailor-made-decisions, secrecy provisions)

III. Measures against “unfair” competition in the domestic tax system

1. General anti-avoidance rules

2. CFC legislation

3. Restrictions of deduction of payments to tax-haven-entities

4. Other

* Mestre em Direito. Master in European Legal Studies, College of Europe, Bruges. Assistant of the LisbonUniversity. Currently Administrator of the European Parliament. The opinions expressed do not bind thisinstitution.

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IV. Measures against “unfair” competition at the international level in which Your country

is involved

1. Double taxation agreements

2. EC (Code of Conduct)

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I. General Aspects of the domestic tax situation

1. The notion of “tax competition” in domestic legal and economic science

Domestic legal science concentrates mainly on the characterisation of the tax regime of free

trade zones in view of the code of conduct for business taxation (hereafter the Code)1 and on

its nature of 'soft law'. As regards the scope of the Code, it is acknowledged that the Code

lacks precision as to whether social security contributions are included.2

As far as tax competition between Member States is concerned, Portuguese scholars recall

that the interplay of freedoms of movement guaranteed by the EC Treaty and national tax and

company law provisions needs to be taken into account. Companies or firms can develop a

business presence in another Member State by means of primary or secondary establishment.

That right must however at present be exercised against a background of non-homogeneous

national tax and company laws. This does not necessarily constitute a problem for those

companies: just as they manage their resources so they can optimise their production and

minimise their costs, they will also naturally exploit the differences between national rules to

their own benefit and will choose to establish themselves in the Member State which offers

the greatest advantages. In Centros,3 the European Court of Justice has explicitly allowed

companies to choose the location in the E.C. that best suits their interests and those of its

shareholders, thus opening the door to competition among national rules as an alternative

approach to harmonisation, in order to ensure the completion of the internal market. It

remains to be seen whether the Court has duly pondered the less desirable regulatory

consequences which may result from its decision as all Member States may tend to align their

legislation with the Member State which, by offering the most favourable legal and economic

conditions to companies in its territory, attracts the largest number of firms. In view of the

impeding fear of a race to the bottom4 that may result from competition among national

1 M.H. Freitas Pereira, "Concorrência fiscal prejudicial - O código de conduta da União europeia" Ciência eTécnica Fiscal 390 (1998) 205, at 213, 215 (hereafter Concorrência fiscal prejudicial).2 António Carlos Santos/Clotilde Celorico Palma, "A regulação internacional da concorrência fiscal prejudicial"Ciência e Técnica Fiscal 395 (1999) 7, at 17 (hereafter A regulação internacional).3 Case C-212/97 Centros [1999] ECR I-1459.4 See Alex Easson, "Tax Incentives for Foreign Direct Investment. Part I: Recent Trends and Countertrends"IBFD Bulletin (2001) 266-274 at 270.

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rules5, this case gives a new impetus to the debate on whether integration in this area can best

be pursued by legislative harmonisation through the adoption of specific Community rules or

by spontaneous harmonisation through market forces.6

2. The political attitude of the government towards tax competition

Portugal has defended during the negotiations on the wording of the code of conduct, that

dependent or associated territories of the Member States should be included, even when they

do not integrate the territory of the Union, since their exclusion could cause activities to

relocate in territories outside the scope of application of the Code7.

The Portuguese government emphasized the double standard resulting from the different

procedures and criteria applicable to state aid measures and measures under the scope of the

Code.8

By insistence of the Portuguese delegation the code of conduct includes a para. G on taking

into consideration the specific characteristics and constraints of ultraperipheral regions and

small islands9. Ultraperipheral regions are currently provided for in Article 299 of the EC

Treaty. The Treaty of Amsterdam introduced major changes in relation to article 299 (2) EC

to establish the general principle that the Treaty applied to the French overseas departments,

the Azores, Madeira and the Canary Islands. Together with that general rule, there was

provision for the Council, acting by a qualified majority on a proposal from the Commission

and after consulting the European Parliament, to adopt specific measures aimed, in particular,

at laying down the conditions of application of the Treaty to those regions, including common

policies.

In accordance with that provision, the areas affected by the specific measures are customs and

trade policies, fiscal policy, free zones, agriculture and fisheries policies, conditions for

supply of raw materials and essential consumers goods, State aids and conditions of access to

5 On competition between legal orders, see Wolfgang Schön, "Tax competition in Europe - the legal perspective"EC Tax Review 2 (2000), 90-105 at 91 et seq (hereafter Tax competition).6 Pedro Cabral/Patrícia Cunha, "«Presumed innocent»: companies and the exercise of the right of establishmentunder Community law" (2000) 25 E.L.Rev 157-164, at 160-161 and 163-164.7 Palma, Clotilde Celorico, "Código de conduta comunitário da fiscalidade da empresa versus relatório da OCDEsobre as práticas da concorrência fiscal prejudicial: A concorrência fiscal sob vigilância", Fisco 86/87 (1999) 3-23, at 6 (hereafter Código de conduta comunitário da fiscalidade da empresa).8 Palma, "Código de conduta comunitário da fiscalidade da empresa" (1999) at 9.9 Palma "Código de conduta comunitário da fiscalidade da empresa", (1999) at 8 and 10.

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structural funds and to horizontal Community programmes. This provision lists the reasons

which may prompt the Council to determine the conditions under which certain provisions of

the Treaty are to apply to those territories. The reasons lie in the structural, social and

economic situation of those territories, which is compounded by their remoteness, insularity,

small size, difficult topography and climate and their economic dependence on a few

products. Finally, when adopting these measures, the Council must take into account the

special characteristics and constraints of the outermost regions. However, the integrity and

coherence of the Community legal order must not be undermined.

As far as the Madeira framework is concerned, the position of the Portuguese authorities is to

avoid its characterisation as a territory under the scope of the code of conduct, mainly through

a comparison with other tax regimes in Europe.10 Portuguese authorities also stress that the

regime is necessary to the development of Madeira and Santa Maria, and that its cost-benefit

is proportionate to the aims pursued.11 Accordingly, under the current framework of tax

competition, the Madeira and Santa Maria free zones are considered by Portuguese authorities

as an element of competitivity of the Portuguese financial sector.12 For this purpose, a closer

link between tax benefits and the development of the Madeira territory was introduced, thus

diminishing its characterisation as a tax haven or an offshore territory13. The commission set

up to study the reform of Portuguese international taxation proposed a gradual evolution of

the framework in view of stabilising at a final tax tax rate of 10%14. The amendments made to

the MFZ framework in the 2002 budget take in this proposal. Accordingly, a gradual increase

of 1% per annum is provided for (see below). This legislative amendment aims at removing

restrictions based on the "subject to tax" clause.

Portugal set a political condition, according to which the adoption of the directive on interest

and royalties depends on the previous adoption of the directive on taxation of interest income.

However, the current separate discussion of both directives does not indicate that this

condition has been observed by Community institutions.

10 For a comparison between the MFZ and other free trade zones and coordination centres, see V.T. Afonso,"Regiões autónomas dos Açores e da Madeira", Fisco 24 (1990) 3-11, at 9-10; William Cunningham, "Aexperiência internacional com as zonas offshore", Fisco 33 (1991) 3-6; Manuel Castelo Branco, "Constituição eregisto de sociedades", Fisco 58 (1999) at 18-120.11 Freitas Pereira, "Concorrência fiscal prejudicial" (1998) at. 213.12 Comissão de estudo da tributação das instituições e produtos financeiros, A Fiscalidade do sector financeiroportuguês em contexto de internacionalização, Cadernos de Ciência e Técnica Fiscal 181 (1999) at 253.13 Comissão de Reforma da Fiscalidade Internacional Portuguesa, Relatório Final, Ciência e Técnica Fiscal, 395(1999) 103-182, at 137 (hereafter Relatório Final).14 Comissão de Reforma da Fiscalidade Internacional Portuguesa, Relatório Final (1999) at 138.

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As far as the discussion of source/home State taxation is concerned, Portugal considers that

the adequate forum to deal with this issue is the bilateral level15.

II. Elements of tax competition in the domestic tax system

1. Tax rates

The standard corporate income tax rate is 30%16. A reduced tax rate of 20% is applicable to

entities that do not exercise business activity as their main purpose. A reduced corporate tax

rate of 25% applies for 7 years to taxable profits of real estate management and investment in

companies. Immovable property rental income derived by qualifying companies is exempt

from withholding of corporate income tax.

Madeira

Articles 33 and 34 EBF are one of relevant items of Portuguese legislation as regards tax

competition17. Is is also an example of the ongoing tax reform since 1989, characterised by

frequent amendments, resulting in a sort of patchwork quilt of rules. This framework has been

considerably amended in view of adapting it to Community law and to the reappraisal of tax

benefits resulting from Decreto-Lei 84/93 of 18 March.

15 Freitas Pereira, "Concorrência fiscal prejudicial" (1998) 205-219, at 218-219; idem, "Concorrência fiscalprejudicial - O código de conduta da União europeia", I Congresso Internacional de Direito Fiscal. A Fiscalidadena União Europeia. Presente e Futuro (Porto, 2000) 131-145, at 145.16 Article 80 CIRC as amended by Law 109-B/2001 of 27 December.17 The frequent legal changes have produced abundant literature, see, inter alia, Rui Barreira, "Problemas doregime fiscal da zona offshore da Madeira", Fisco 33 (1991) 18-21; Celeste Cardona, "Benefícios fiscais: Oregime de tributação de juros pagos a não residentes através de entidades instaladas nas zonas francas", Fisco 53(1993) 22-29; M. H. Freitas Pereira, "Benefícios fiscais e zona franca da Madeira", Ciência e Técnica Fiscal 382(1996) 35-46; Manuela Duro Teixeira, "As limitações às actividades das sucursais financeiras exteriores daszonas francas portuguesas", Ciência e Técnica Fiscal 393 (1999) 129-160; Francisco Costa, "Critérios eobjectivos da revisão do regime fiscal da zona franca da Madeira", in Fisco 58 (1999) 3-12; Manuel CasteloBranco, "Constituição e registo de sociedades", Fisco 58 (1999) 14-24; João Fernandes, "Regimes especiaisinstituídos pela nova legislação no âmbito da zona franca da Madeira", Fisco 58 (1999) 26-34; Paulo Macedo,"Sucursais financeiras exteriores: Análise de alguns aspectos práticos", Fisco 58 (1999) 36-39 (hereafterSucursais financeiras exteriores); Manuela Duro Teixeira, "Sucursais Financeiras Exteriores. Alteraçõesintroduzidas pela Lei n.º 30-F/2000, de 29 de Dezembro", Ciência e Técnica Fiscal 401 (2001) 157-184; JoãoFernandes, "A reforma fiscal e as alterações ao regime do Centro Internacional de Negócios da Madeira, Fisco95/96 (2001) 41-51; José Maria de Albuquerque Calheiros, "Zona franca da Madeira - Alterações recentes, emespecial as relativas às sucursais financeiras exteriores", Fisco 99/100 (2001) 45-52 (hereafter Alteraçõesrecentes).

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The Madeira free trade zone (hereafter MFZ) consists of an industrial free trade zone, a

financial services centre, an international services centre and a shipping register18. All

companies incorporated under the MFZ legislation are subject to the same regulations and

principles as any other Portuguese company. Such companies are subject to – and exempt

from – Portuguese tax19.

Madeira is subject in general to Portuguese law, which does not recognise the existence of

trusts as such. Portugal has not ratified the Hague Convention on the law applicable to trusts

and their recognition. Nonetheless, when the MFZ was enacted, provision was made for the

creation of offshore trusts20. The property of trusts must be outside Portugal, and their income

must be derived from outside the country. Trusts must have Madeira-resident trustees. All

income earned by a trust and all income distributed in favour of a beneficiary is free of tax in

Madeira unless the source of that investment income is Portugal in which case it is taxed in

the hands of the trustee.

The industrial free trade zone has been created to receive activities which, by their nature,

involve the physical movement of goods. All goods, regardless of their nature, quantity, origin

and destination, may be imported into the Zone in order to be stored, repaired or transformed

with few formalities and with a total exemption of import duties and quotas, provided they are

not a threat to national security or public health21. Until 31 December 2011, entities licensed

to carry out operations of an industrial nature, or other activities accessory or complementary

thereto, in the designated areas, are entitled to exemption of corporate income tax in case of

licensing approved before 31 December 2000. Similarly, the shareholders or partners of the

abovementioned entities are entitled to exemption of income tax (corporate or personal

income tax) on the dividends or profits declared by those entities, or on interest or other funds

made available by them, until 31 December 2011.

As regards the financial centre, both international and Portuguese banks may establish

offshore subsidiaries or branches anywhere in Madeira to take advantage of the MFZ

Legislation. Permitted activities include foreign exchange, the management of investment

funds and the issuance of negotiable securities as well as a normal range of banking services.

18 For a brief description of the framework, see José Manuel Braz da Silva, Os Paraísos Fiscais. Casos práticoscom empresas portuguesas (Lisbon, 2000) at 106-115.19 Rui Barreira, "Problemas do regime fiscal da zona offshore da Madeira", Fisco 33 (1991) at 20.20 Luís Oliveira, "O uso de trusts na zona franca da Madeira", Fisco 55/56 (1993) 36-40; Manuel Castelo Branco,"Constituição e registo de sociedades", Fisco 58 (1999) at 20-21.21 On the tax benefits to industrial free trade zones, Maria Teresa Veiga Faria, "Benefícios fiscais a zonas francasindustriais", Fisco 58 (1999) 42-49.

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Unless a bank holds an international banking license, it cannot supply financial services to

Portuguese residents22.

A shipping register is kept by the international shipping register of Madeira, which is part of

the institutional set-up of the MFZ. It covers shipping industry activity, other than income

derived from the transport of passengers or cargo between domestic ports. Shipping

companies based in the autonomous region of Madeira qualify for exemption from

corporation tax up to 31 December 2011 for profits arising from an authorised activity;

exemption from corporate tax or tax on personal income for profits or dividends distributed to

members of, or holders of shares in, the entities concerned; exemption from personal income

tax for crew members of vessels registered in the international shipping registry in respect of

the remuneration they receive in that capacity and for as long as their vessel's registration

remains valid.

The MFZ include a wide array of tax benefits, among which tax exemptions on income tax

whose scope varies depending on each activity pursued. The exemption of personal and

corporate income taxes until 31 December 2011 is subject in general to a double condition:

the income is connected with the activity pursued, and the income is not connected with the

remaining part of the Portuguese territory23.

Accordingly, entities set up in the free Zones of Madeira and Azores benefit from the

following tax incentives, inter alia:

- Exemption from personal and corporate income taxes (IRS and IRC) on income derived

from an activity carried out therein up to 31 December 2011, under the following

conditions:

(a) Entities established in the respective demarcated industrial zone, in respect of income

derived from the exercise of any industrial activity as well as any activity accessory or

complementary thereto;

(b) Entities duly authorised to such effect which carry out a sea transport activity in respect of

income derived from the exercise of such authorised activity other than income from the

transport of passengers or goods between domestic harbours;

22 On banking and insurance, see Eduardo Pedrozo, "O seguro as zonas offshore e a praça offshore da Madeira"Fisco 33 (1991) 22-24; José Marques de Almeida, "A banca e os seguros perante as zonas offshore" Fisco 33(1991) 25-28; Macedo, "Sucursais financeiras exteriores" (1999) 36-39.23 The conditions identified by Alberto Xavier, Direito Tributário Internacional (Coimbra, 1993) p. 407, are stillapplicable. See Comissão de Reforma da Fiscalidade Internacional Portuguesa, Relatório Final (1999) at 140.

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(c) Credit institutions and financing companies in respect of income derived from their

activity therein, provided that they do not carry out any operations with residents of the

Portuguese territory or with a permanent establishment of a non resident situated therein,

excepting those entities established in the free Zones other than credit institutions, financing

companies or financing affiliates carrying out operations within the scope of their activities

with residents or permanent establishments of non residents, and provided that they do not

carry out any operations with non residents in a relationship of dominion with credit

institutions or financing companies resident in the Portuguese territory, outside the free zone,

or with financial entities directly or indirectly participated by entities resident in the

Portuguese territory, other than the free zones;

(d) Entities whose activity is to manage investment funds, in respect of income derived from

management of funds, whose participation units are exclusively acquired, upon their issuance,

by non residents in the Portuguese territory, other than their permanent establishments

situated therein, and whose investments are exclusively made in financial assets issued by non

residents or other assets situated outside the Portuguese territory, without prejudice to the fact

that the net global value of such fund may be formed up to a maximum of 10% by cash, bank

deposits, deposit certificates or investment in interbank markets;

(e) Entities carrying on a non-life insurance or reinsurance activity, and operating exclusively

in connection with risks situated in the free Zones or outside the Portuguese territory, in

respect of income from their activity;

(f) Companies managing pension funds and life insurance or reinsurance companies, which

are exclusively engaged with non residents in the Portuguese territory, excluding their

permanent establishments situated therein, in respect of income derived from their activity;

(g) Domestic holding companies (SGPS) in respect of income derived from corporate rights

(including profits and plus values) held in companies not resident in the Portuguese territory,

excepting the free Zones, or in the territory of other EC Member States;

(h) Entities referred to under subparagraph (a), in respect of income derived from the

activities exercised in the demarcated industrial zone not covered by such subparagraph (a), as

well as all other entities not mentioned in the previous subparagraphs, in respect of income

from their activities comprised within the institutional scope of the respective free zone,

provided that such activities concern in both cases operations carried out with entities

established in the free Zones or non residents of the Portuguese territory, excepting any

permanent establishment situated therein and outside the free Zones.

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- Exemption from taxes (IRS and IRC), up to 31 December 2011, on income (profits au pro

rata of the total amount of both exempted and not exempted fractions as derived from

income realised outside the Portuguese territory, and interest) attributed to companies

participating in their capital and which are not resident entities of the Portuguese territory,

as regards companies mentioned in subparagraphs (a), (b), (g) and (h) above.

- Exemption from IRC on interest from loans to entities situated in the free zones, provided

that the result of the loan is investment in or the normal functioning of the loan takers in

the free zone, and provided that the lender is not resident in the remaining Portuguese

territory, other that permanent establishments therein.

- Exemption from taxes (IRS and IRC) on income paid to third persons as royalties,

technical assistance and know-how, where the operations underlying such payments are

related with the activity carried out in the free Zone.

- Exemption from stamp duty in respect of documents, contracts, operations, acts and deeds

in which participate entities situated in the Free Zones, unless the counterpart or the

recipient thereof is an entity resident of the domestic territory.

For the purpose of this provision, entities under the scope of the Personal Income Tax and

Corporate Income Tax Codes and not considered resident in another State due to the

application of a double tax convention, are considered resident in Portuguese territory.

The MFZ was considered an example of income tax as a voluntary tax24. However, the

procedure leading to the authorisation of tax aid by the Commission led to the introduction of

a provision concerning new entities licensed in the. Accordingly, pursuant to Article 34 EBF,

entities licensed as of 2001 are subject to a phasing in regime until 2011 whereby their

income is subject to tax at an increasing rate:

(a) For entities mentioned in subparagraphs (d) to (f) and (h), income is subject to IRC at 1%

if licensed in 2001 and 2002; 2% if licensed in 2003 and 2004, and 3% if licensed in 2005 and

2006;

(b) For credit institutions and financing companies, in case the conditions mentioned in

subparagraph (c) above are fulfilled, income is subject to IRC at 7,5% if licensed in 2001 and

2002; 10% if licensed in 2003 and 2004, and 12,5% if licensed in 2005 and 2006.

24 Robinson, Bill, "Estratégia fiscal na União Europeia: Os impostos indirectos serão efectivamente preferíveis?",Fisco 80/81 (1997) 67-80, at 74.

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Companies wishing to benefit from the tax incentives must provide documentary evidence

proving that all transactions are with non-Portuguese residents. Article 33(14) EBF clarifies

the need to ensure an effective control of the non-resident status, thereby listing the

documents needed to prove such status.

No mention was made to this regime at the ECOFIN meeting of 1 December 199725, which

has been notified to the Commission since 1986. The regime of financial and tax aid was

authorised in 1987, pursuant to the exemption provided for in former Article 92(3)(a) of the

EC Treaty. This authorisation was subsequently prolonged for two additional periods, of three

and six years respectively. Pursuant to the most recent prolongation decision, the Commission

decided not to object to the application of the regime up to 31 Dezember 2000, at which date

the situation would be reviewed again. Under the terms of the Commission's most recent

decision, tax aid (i.e., full exemption from direct taxes until the end of 2011) may be granted

to industrial, financial and service firms that have been established in the MFZ before 1

January 2001.

Following the Commission's adoption in 1998 of the guidelines on State regional aid,26 the

Commission proposed to all the Member States that all the regional aid schemes in force on 1

January 2000 be amended so as to bring them into line with the guidelines as of that date. In

particular, the guidelines contain the principle of prohibition of regional aid aimed at reducing

a firms' current expenses (operating aid), while allowing aid in regions eligible for the

derogation in Article 87(3)(a) EC Treaty, provided that its level is proportional to the

handicaps it seeks to alleviate. This condition must also be verified in the case of operating

aid granted in outermost regions, where such aid is intended to reduce the additional costs of

carrying on economic activity that are inherent in the handicaps identified in Article 299(2)

EC Treaty. The main effect of the changes would be that any operating subsidies granted after

1 January 2000 are limited in time and should be made degressive. The Commission having

authorised application of the arrangements up to 31 December 2000 only, any future

implementing rules have to be notified and examined b the Commission prior to being

implemented.

Accordingly, the Commission opened in July a formal investigation procedure, on the

grounds that the compatibility of the existing aid regime for the MFZ with Community law

25 Freitas Pereira, "Concorrência fiscal prejudicial" (1998) p. 215.26 COM(2000) 147.

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had not been established27. As far as direct taxation is concerned, the Commission reserved its

right to decide what guidelines to use, inter alia, in the light of the outcome of work currently

being done by the Council's code of conduct working party28.

It is to be remembered that the particular circumstances of Madeira are explicitly referred to

in Article 299(2) of the EC Treaty, which permits specific measures directly related to free

zones, state aids and tax policy.

"Internal" areas

A scheme aiming to combat human desertification and accelerated recovery of "internal"

areas includes a reduction of IRC to 25% or 15% for companies mainly active in the

beneficiary areas, depending on whether the company is subject to the general IRC rate or to

the simplified regime, respectively. The regime also provides for an accelerated depreciation

for investment not exceeding 500000€. The measures have been approved by the Commission

without opening proceedings29.

Microbusinesses

As of 1999, the tax rate on corporate income applicable to microbusinesses in 1999, 2000 and

2001 is 20%. Microbusinesses set up after 1 January 1999 and at lest 75% of whose registered

capital is held by people of between 18 and 35 years of age are exempt from corporate income

tax in 1999, 2000 and 2001 if the fact of setting up the business results in net job creation.

Microbusinesses which carry on their activities in "internal" areas of the national territory are

furthermore entitled to a reduction of the rate of IRC to 15% and a tax credit equal to 15% of

the cost of additional relevant investments made during the tax period, within the limit of 35%

of the amount of their corporate income tax liability. These limits are raised by 5% where at

least 75% of the registered capital of the microbusiness is held for the three years concerned

by people of between 18 and 35 years of age.

2. Tax accounting (general or specific for foreign investment, e.g. artificial definition of

the tax base, tax deferral etc.)

27 OJ C 301 of 21.10.2000, p. 4-12.28 Written question P-1373/00 by Sérgio Marques (PPE-DE) to the Commission, OJ C 46 E, 13.2.2001, p. 180-181.29 See OJ C 342/2001 of 5.12.2001, at 7.

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Reinvested capital gains

As regards capital gains arising from a conveyance in return for payment of tangible fixed

assets, the difference between the realised capital gains and capital losses on tangible fixed

assets is exempted if the total consideration is reinvested in the acquisition, production or

construction of any elements of tangible fixed assets until theend of the third financial period

following its realisation.

Research and development expenses

An IRC taxable person who is resident on Portuguese territory and carries on as his main

business a commercial, industrial or agricultural activity, and non-residents having a

permanent establishment therein, can obtain a tax credit for investiment in research and

development (hereafter R&D). The beneficiaires may deduct from their taxable income an

amount equal to expenditure on R&D, provided this is incurred in Portuguese territory, in

accordance with a dual rate: a basic rate of 20% of the expenditure incurred in that period; and

50% of the expenditure accrual in thar perior with regard to the simple arithmetic average of

the previous two accounting periods.

Contractual investments

This tax incentive is available by means of contracts to be concluded between the Portuguese

State and the sponsoring entity.30 Investment projects in productive units until 31 December

2010 of an amount equal or above 4987978,97€ may benefit inter alia from a tax credit of a

between 5% to 20% of the cost of relevant investments.

A tax credit in IRC of 10% to 20% of the cost of relevant investments may be given to entities

sponsoring the investment project. Double economic taxation under the conditions provided

for in Article 46 Corporate income tax Code (hereafter CIRC)31 is eliminated where the

investment is made through the incorporation or acquisition of foreign companies. This

framework does not apply to investments in free zones or in territories with a more favourable

tax regime.

30 See Grupo de Trabalho de Revisão do Regime Fiscal dos Contratos de Investimento, Relatório, Ciência eTécnica Fiscal 395 (1999) 182-275.31 See below.

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Micro and small enterprises

Qualifying additional investments of micro and small enterprises entitle to a deduction of the

taxable base equal to 10% of the relevant additional investment. The deduction may not

exceed an amount equal to 30% of the taxable base.

3. Double taxation relief (inbound and outbound) and other advantages for cross-

border-business

Elimination of economic double taxation of resident companies is provided for in Article 46

CIRC. According to this provision, taxable income corresponding to distributed profits by

resident entities subject to and not exempted from IRC or subject to gambling tax, is deducted

in case of a minimum holding of 10% for 2 years or since incorporation. The same applies to

resident entities holding a participation in entities resident in another Member State, provided

that both entities fulfil the conditions set in Article 2 of EC Directive 90/435 of 23 July. A tax

credit of 60% (provided for in Article 84 CIRC) is available for situations of economic double

taxation not covered by Article 46 CIRC32.

As concerns international double taxation, Article 85 CIRC allows for a credit where foreign

income is included in the taxable base. This credit corresponds to the lowest amount resulting

either from income tax paid abroad, or the amount of corporate income tax, calculated before

deduction, corresponding to income that may be taxed in Portugal33.

Transfer pricing

The current transfer pricing regime is provided for in Article 58 CIRC34. This provision sets

out an arm's length principle applicable to commercial and financial relations between a

taxpayer and any other entity which are under special relations.

32 José Carlos Gomes Santos, "Crédito de IRC (Artigo 72.º do CIRC) Atenuação da dupla tributação económicaou benefício fiscal?" Fisco 23 (1990) 3-6; José Casalta Nabais, Direito Fiscal (Coimbra, 2000), at 381 (hereafterDireito Fiscal).33 See Casalta Nabais, Direito Fiscal (2000), at 198-199 and 382.34 As amended by Decreto-Lei 198/2001, de 3 de Julho. See the critics to the previous regime as regards theabsence of detailed rules and procedures on transfer pricing in Tomás, J. J. Amaral, "Os preços de transferência",Fisco 29 (1991) 17-24, at 23.

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Special relations are defined as the significant influence in management decisions of an entity.

Article 58(4) CIRC lists exhaustively the situations which characterise the concept of special

relations, which include, namely, a criteria of 10% share ownership; and of indirect and/or

family control.

The new regime follows closely the OECD guidelines on transfer pricing35, inter alia as

concerns the definition and the methods to determine the arm's length principle36.

The operations between entities under special relations must take place on normal market

commercial terms (i.e. on an arm's length basis). This principle centres on comparability, in

order to determine whether a certain operation between independent firms is similar to a

transfer between entities under special relations.

The taxpayer is under an obligation of adopting the method that may allow the highest level

of comparability between its operations and those which would be negotiated between

independent firms. Comparability must be determined by taking into account the

characteristics of goods, rights or services, the market share, the economic and financial

situation of the entity, the business strategy and other relevant characteristics of the entities

involved, their roles in the operation, equity, and risk.

The methods listed in this provision are based on the operation - the comparable uncontrolled

price method; the resale price method, and the cost plus method - and on the profit of the

operation - the profit split method, the transactional net margin method, or any other more

accurate method37.

The taxpayer is under the obligation of keeping the documentation concerning its transfer

pricing policy.

The transfer pricing framework is applicable not only to operations between entities resident

in the Portuguese territory, but also to operations between non-resident entities and a

permanent establishment in Portuguese territory, or between the latter and other permanent

establishments outside the Portuguese territory.

35 OECD, Transfer princing guidelines for Multinational Enterprises and Tax Administrations, Paris, 1995. SeeMaria Teresa Veiga Faria, "Preços de transferência – Problemática Geral", Ministério das Finanças, XXXAniversário do Centro de Estudos Fiscais. Colóquio A Internacionalização da Economia e a Fiscalidade (Lisboa,1993), 397-440; Maria dos Prazeres Lousa, "Preços de transferência e acordos de dupla tributação", Ciência eTécnica Fiscal (398) 2000, pp. 47-69, at 55-57 (hereafter Preços de transferência); Stephen Callahan, "As novasregras de preços de transferência em Portugal", Fisco 97/98 (2001) 39-46.36 Paula Rosado Pereira, "O novo regime dos preços de transferência", Fiscalidade 5 (2001), 23-47, at 24, 31, 35(hereafter O novo regime).

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The tax administration may adjust the accounts of the entities if the above mentioned

conditions are present. Article 57(11) provides for a correlative adjustment procedure as far as

special relations with another entity subject to IRS or to IRC are concerned38.

Even though Portugal reserved the right to specify in its conventions that it will proceed to a

correlative adjustment, Article 57(12) extends it to non-resident entities as a result of the

application of a double taxation convention.

It is to be reminded that Portugal has also signed and ratified the EC Arbitration convention

90/43639 and therefore is bound to adjustment operations under the scope of that convention40.

As a result of the abovementioned reservation, Article 9(2) of the OECD Model was

suppressed from conventions with Italy and Germany. Other conventions include that

paragraph, provided that the other State considers the adjustment to be justified41.

Article 58 CIRC is further developed by Portaria no. 1446-C/200142. Advance pricing

arrangements are not provided in Portuguese law whereas cost contribution agreements are

provided for in Article 11 of Portaria no. 1446-C/2001.

4. Procedural advantages

Article 63 LGT provides that access to data under bank secrecy generally depends of court

authorisation43. As regards refusal to show documents or authorisation for its consultation,

Article 63B LGT allows for direct access to bank information by the tax administration44.

37 On the different methods of comparability, see Miguel Teixeira de Abreu, "Os preços de transferência nocontexto internacional", Fisco 18 (1990) 9-15, at 11-14.38 As to the application of this procedure, see Rosado Pereira, "O novo regime" (2001), 45.39 Decreto do Presidente da República n.º 73/94, de 19 de Outubro, D.R. de 19.10.1994, n.º 242, I Série-A, p.6326; Resolução da Assembleia da República n.º 60/94, D.R. de 19.10.1994, n.º 242, I Série-A, p. 6326-35;Ministério dos Negócios Estrangeiros, Aviso n.º 26/95, D.R de 17.1.1995, n.º 14, I Série, p. 235-6.40 Cunha, Patrícia Noiret, "Settlement of Disputes in Portuguese Tax Treaty Law" in Settlement of Disputes inTax Treaty Law (2002) forthcoming. See further Correia, Catarina Pinto, "Les prix de transfert. Les résolutionsau problème de la double imposition. La procédure arbitrale et les accords préalables de prix", Direito e Justiça,13 (1999) 255-310; Carvalho, Maria da Graça Simões, Aplicação das Convenções sobre a Dupla Tributação(Lisboa, 2000) at 154.41 Margarida Mesquita (1998) As convenções sobre dupla tributação, Cadernos de Ciência e Técnica Fiscal 179(Lisboa, 1998), at 149 (hereafter As convenções).42 Portaria n.º 1446-C/2001, de 21 de Dezembro, D.R. - I-Série-B, n.º 294, pp. 8400(20) a 8400(28).43 On bank secrecy in general, see Maria Eduarda Azevedo, "O segredo bancário", Fisco 33 (1991), 12-17.44 A synthesis of this provision can be found in José Maria de Albuquerque Calheiros/Luís Cabral de Sousa,"Breve nota sobre a recente proposta de lei de autorização legislativa relativa à reforma da tributação do

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This rule applies inter alia when the taxpayer is the recipient of tax benefits or of privileged

tax regimes, for the purpose of controlling the application of the its underlying conditions.

However, the document whereby the tax administration serves the request must be reasoned.

III. Measures against “unfair” competition in the domestic tax system

1. General anti-avoidance rules

A general principe of substance over form is provided for in Portuguese legislation thereby

permitting the consideration of an economic reality other than the legal form which is agreed

upon by the parties.45

The freedom of contracting parties is limited by a business purpose test: when the transaction

is exclusively or principally tax-motivated, the beneficial tax treatment will be denied and a

recharacterisation of the facts for tax purposes will occur.46

The concept of simulation, originating from civil law, is specially provided in tax law. In case

of illegal tax sham (simulation), where contracting parties have intended to create other legal

consequences than those created by the documents, taxation occurs on the reality effectively

intended by the parties rather than on the artificial transaction.

2. CFC legislation

Portuguese tax rules on controlled foreign corporations are set out in Article 60 CIRC. A

controlled foreign corporation is defined as an entity located in a low-tax jurisdiction and

controlled by Portuguese residents.47

rendimento das pessoas singulares e à adopção de medidas de combate à evasão e fraude fiscal", Fisco 92(2000) 45-53, at 53.45 José Luís Saldanha Sanches, "Abuso de direito em matéria fiscal: Natureza, alcance e limites" Ciência eTécnica Fiscal 398 (2000) 9-44.46 Santos/Palma, "A regulação internacional" (1999) at 18. Before the introduction of the general anti-avoidancerule in Portuguese law, see Luís Manuel Teles de Menezes Leitão, "Evasão e fraude fiscal internacional", in:Ministério das Finanças, XXX Aniversário do Centro de Estudos Fiscais. Colóquio A Internacionalização daEconomia e a Fiscalidade (Lisboa, 1993) 299-330; idem, "A evasão e a fraude fiscais face à teoria dainterpretação da lei fiscal", in: Luís Manuel Teles de Menezes Leitão, Estudos de Direito Fiscal (Coimbra, 1999)9-45.47 Câmara, Francisco Sousa da/Bernardo Ayala, "Portugal - CFC Taxation", Fisco 78/79 (1996) 75-90 (hereafterCFC Taxation); Adelaide Passos/Luís Brito da Mana, "Portugal", in European Taxation (2000) 71-72.

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The profits of companies resident outside Portugal and subject to a taxation regime which is

more favourable than the one in Portugal are imputed to the Portuguese resident shareholders.

Imputation is made in proportion to shareholding and independently of distribution. This

provision is applicable where the Portuguese resident shareholders hold, directly or indirectly,

at least 25% of the non-resident company or where more than 50% of the non-resident

company is held, directly or indirectly, by Portuguese residents, each holding 10%.

Qualifying participators must declare and compute annually their controlled foreign

corporation share in their personal taxable income.

3. Restrictions of deduction of payments to tax-haven-entities 48

Article 59 CIRC determines that payments to non-resident entities in States with a clearly

more favourable tax regime are non-deductible. In order to prevent the application of this rule,

the burden of proof – that payments correspond to genuine operations carried out and are not

abnormal in character nor of an excessive amount – falls on the taxpayer.

A more favourable taxation regime is held to exist where:

– The non-resident is resident in a territory which is included in a listed approved by the

Minister of Finance; or

– The non-resident is not subject, in the country of residence, to income tax identical or

equivalent to IRS or IRC; or

– the effective corporate tax rate applicable to such payments is equal or below 60% of the

tax due if the entity in question was considered resident in Portuguese territory.

The listing of territories with a favourable tax regine was updated in 2001.49

4. Other

The CIRC contains several specific anti-abuse rules50. Article 61 CIRC deals with thin

capitalisation. This provision applies to loans made by non-resident shareholders to resident

48 Luís Manuel Teles de Menezes Leitão, "A introdução na legislação portuguesa de medidas destinadas areprimir a evasão fiscal internacional: O Decreto-Lei n.º 37/95, de 14 de Fevereiro", idem, Estudos de DireitoFiscal (Coimbra, 1999) 160-172; Casalta Nabais, Direito Fiscal (2000) at 375-377.49 See Portaria 1272/2001 of 9 November, replacing the list approved by Portaria 377-B/94, of 15 June.

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companies only51. The non-resident must have a special relation with the resident company52.

Accordingly, when the indebtedness of a Portuguese company towards non-residents with

whom it is specially related, exceeds the debt/equity ratio of 2:1, interest paid on the loan

portion which is in excess of such ration is not tax deductible at the borrowing resident

company level. A safeguard clause is established Article 61(6) and (7): provided that the

taxpayer proves - taking into consideration the nature of its business, the economic sector it is

included in, the size of the company and other relevant criteria - that the same level of

indebtedness would have been obtained under similar conditions from a third, non-related

party, the rule does not apply. The consequence of failing the "thin capitalisation" test is that

interest on the portion of debt considered to be excessive is disallowed as tax deductible.

Portuguese law does not indicate whether amounts paid out as interest on excessive debt will

be liable to taxation as interest or dividends. However, defining these amounts as dividends

would result in double taxation, since they would not only be taxed on the side of the debtor -

through non-deductibility of interests - but also on the side of the creditor - at the moment of

paying out such "dividends" (withholding tax would then apply). Contrary to other

legislations of EU Member States, there are no special provisions for certain sectors of

activity, such as banking or insurance, as well as for certain types of organisations, such as

holding companies and company groupings whose profits are submitted to the Revenue

Authorities on a consolidated basis.53

According to Article 123 CIRC, the income of non-resident entities obtained in Portuguese

territory and subject to CIRC cannot be transferred outside its territory without evidence of

payment of tax or of guarantee of its future payment.

50 On anti-abuse clauses in Portuguese law, see Ana Paula Dourado, "O princípio de direito comunitário da não-discriminação na tributação sobre o rendimento em Portugal", in: António Margos (org.), I CongressoInternacional de Direito Fiscal. A Fiscalidade na União Europeia. Presente e Futuro (Porto, 2000), 185-204, at191-192; Luís Cabral de Sousa, "Relações com territórios de fiscalidade privilegiada. Alterações recentes",Fisco 95/96 (2001) 53-62. On compatibility of national anti-abuse clauses with EC law, see de Kleer, Maurice,"Towards a European Anti-Abuse Doctrine in Direct Taxation?" Intertax 4 (1996) 137-144. On specific anti-abuse clauses, see João Fernandes, "As recentes medidas anti-abuso do Código do IRC", Fisco 74/75 (1996) 9-14.51 Maria dos Prazeres Lousa, "A tributação das filiais de empresas transnacionais e a subcapitalização",Ministério das Finanças, XXX Aniversário do Centro de Estudos Fiscais. Colóquio A Internacionalização daEconomia e a Fiscalidade (Lisboa, 1993) 443-481; Glória Teixeira, "Thin capitalization in the Portuguese taxsystem", Intertax 12 (1996) 472-479; idem, "Thin capitalization in the Portuguese tax system", Intertax 2 (1997)61; Adelaide Passos /Luís Brito da Mana, "Portugal", European Taxation (2000), 71-72, at 72; Patrícia Silveirada Cunha, “A subcapitalização no direito português – Apreciação face ao direito comunitário", in: Estudos emHomenagem ao Professor Doutor Pedro Soares Martinez, vol. II (Coimbra, 2000), 499-546.52 Special relations are defined in Article 58(4) CIRC. See supra.53 Pedro Leite/Patrícia Noiret S. Cunha, "Portuguese thin capitalization law", In-House Counsel International 5(1997).

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Another rule justified by anti-avoidance arguments pertains to taxation of consolidated

profit54. Among other conditions, this regime is applicable in case all companies have its head

office or effective management in Portuguese territory only [Article 63(3)(a)CIRC].

IV. Measures against “unfair” competition at the international level

1. Double taxation agreements

Entities located in Madeira and Santa Maria benefit from all double taxations conventions

celebrated by Portugal, other than the convention with the United States55. This element,

which distinguishes it from other low-tax territories, allows for the possibility of tax planning

in case of matching credit56.

The Portuguese insistence in including the MFZ in the scope of the conventions is considered

to be a major obstacle to the negotiation and/or revision of several double taxation

conventions57. The Portugal-Denmark convention was denounced by the latter due to the tax

regime in Madeira and Santa Maria58.

Whereas denouncing conventions should be a last resort solution, the question might be

solved at Community level through Article 96 EC59. This provision aims at eliminating the

distorsions to the conditions of competition in the common market resulting from differences

between provisions laid down by law, regulation or administrative action in Member States.

54 Ana Paula Dourado, "Impact of non-discrimination principle on Portuguese income tax law", EC Tax Review1 (1997) 10-17, at 12; Passos/Brito da Mana, "Portugal" (2000) at 7155 Manuela Duro Teixeira, "O acordo de dupla tributação entre Portugal e os Estados Unidos e as zonas francasportuguesas. Limitação de benefícios", Fisco 72/73 (1995) 23-32; Câmara/Ayala, "CFC Taxation", Fisco 78/79(1996) 75-90, at 89, n. 29; Margarida Mesquita, "Aplicação das convenções sobre dupla tributação a empresasinstaladas nas zonas francas da Madeira e de Santa Maria", Direito e Justiça (1997) 119-129 (hereafter Aplicaçãodas convenções), at 120 and 129; João Fernandes, "Regimes especiais instituídos pela nova legislação no âmbitoda zona franca da Madeira", Fisco 58 (1999) 26-34, at 27; Macedo, "Sucursais financeiras exteriores" (1999) at39-40 (hereafter Sucursais financeiras exteriores); Maria Teresa Veiga Faria, "Benefícios fiscais a zonas francasindustriais", Fisco 58 (1999) 42-49, at 48; Comissão de Reforma da Fiscalidade Internacional Portuguesa,Relatório Final (1999) 103-182; at 142-143.56 Mesquita, As convenções (1998) at 296-297; Macedo, "Sucursais financeiras exteriores" (1999) at 40; JoséCasalta Nabais, Direito Fiscal (2000) at 199.57 Mesquita, "As convenções" (1998) p. 48-49; Macedo, "Sucursais financeiras exteriores" (1999) at 39.58 Leif Weizman, "Denmark – Government blocks Madeira route", European Taxation 9 (1994); Mesquita,"Aplicação das convenções" (1997) at 119.

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2. EC (Code of Conduct)

The following measures were reviewed by the code of conduct group on business taxation:

holding companies (SGPS); Madeira free zone (hereafter MFZ); shipping register; tax credit

for research and development; industrial free zone; tax credit for restructuring projects in

depressed areas; micro and small enterprises; tax incentives to contractual investments; tax

credit to investment; reinvesment of plusvalues; real estate management and investment

companies; accelerated depreciation; investment funds.60 Only the measures pertaining to

Madeira and Santa Maria free zones were considered damaging by the Primarolo group.61

59 Albert Rädler, "Do National Anti-Abuse Clauses Distort the Internal Market?" European Taxation (1994), p.313.60 For a list updated up to 1999, see Santos/Palma, "A regulação internacional" (1999) at 21-22.61 See annex C to the report of the code of conduct group on business taxation as submitted to the ECOFINCouncil on 29 November 1999.