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How These Changes Fit Into A More General European Pattern And What Future Changes May Be Expected
The 1995 Portuguese Budget marked a further stage in the development of a more mature tax system in Portugal aimed at broadening the tax base and curbing tax avoidance and tax evasion. Many of the proposed alterations do not in reality constitute innovations, but follow measures which have already been implemented in various other European countries. In many respects therefore Portuguese Budget changes reflect EU wide tax trends. This article focuses on key tax areas, including those where there have been major changes in this years Budget, and show how Portugal's experience fits into a more general pattern. In addition, those areas which are likely to see further change in the years to come are highlighted.
Rates of Taxation
Progress on the formal harmonisation of direct taxes within the EU has been slow. However market pressures and the need to attract and retain inward investment has led to a defacto alignment of corporate tax rates in the EU centred around 33% - 40%. This contrasts to the position in the mid 1980s when some EU countries (e.g. the UK) had corporate tax rates in excess of 50%. The current Portuguese tax rate (36%) lies around the European average. However, the fact that the majority of municipalities levy a local 10% tax, raises the effective tax rate to 39.6% which is among the highest in the EU although within the general band noted above. The corporate income tax rate was not changed by the state budget, nor is it likely that the rate will change substantially in the near future.
There has been a similar trend in the rate of personal income tax although this is less easy to quantify because generally the rates are progressive and vary from one country to another . The top rate of tax in Portugal at 40% is the same as the UK's but many other EU countries have top rates in the 50% - 60% band. There is probably more scope for future changes in the rate of income tax than personal tax given the more marked disparities.
Headline tax rates can of course provide only a limited guide to the harmonisation of direct tax in the EU because of the very different ways in which the tax base is computed and in particular the different tax exemptions available. Rather than seek a wholesale alignment of tax rates it is likely that the EU will concentrate in the foreseeable future on putting forward directives in specific areas where different tax regimes can set up barriers to movement within the Community. At the same time various states may harmonise areas of tax where their existing regimes could lead to a loss of tax to other fiscal authorities or be a disincentive to investment. These specific areas will be discussed in greater detail later in this article.
It may be thought that VAT, being effectively an EU tax, would lend itself much more to harmonisation than direct taxes. It is true that for VAT purposes there is a common directive (6th Directive) which is regulated by the various countries in a similar manner. Nevertheless, the procedures that have been adopted, particularly concerning the framework, payment and supporting documentation, show differences from one country to another, for example Portugal uses the VAT "reverse charge" mechanism much more than other EU states. Where harmonisation is particularly lacking is in the rates of VAT applied by the EU Member States which vary from a minimum standard rate of 15% in the case of Germany and Spain (before the recent Spanish Budget) to a maximum of 25% in the case of Denmark.
To date harmonisation trends have had little success. On the other hand, it can be seen that the gradual fall in income tax rates since the 1980s has been complemented by a general increase in VAT rates. This years Portuguese Budget increase of 1% in the standard rate of VAT to 17% was paralleled by a similar 1% rise in Spain to 16%. There was a failed attempt by the UK government to increase VAT on domestic fuel from 8% to 17.5%.
All this leads to the view that in future we can anticipate that the EU will continue its efforts to harmonise VAT rates, despite significant opposition from Member States. At the same time individual countries will tend to a widening of the taxable base and a rise in rates as a way to raise revenue in times of Budget difficulties.
Corporate Tax Losses
The ability to use tax losses generated in one year against profits made in another year is a major advantage for companies, helping them to smooth overall results in good and bad years through the non-taxation of profits.
This has long been recognised as a potential loss of revenue to the Government in many countries particularly so in a period after a recession and many countries now have rules which effectively prevent the use of tax loss companies. A classic example is the UK where the law states that if there is a change of ownership of a company and, under certain conditions, a change in its business within three years, the tax losses at the date ownership changes are lost.
In the case of Portugal, the Budget states that where there is a change in the social objective of the company or the nature of its business is substantially altered, carried forward tax losses cannot be used.
As a general point it should be noted that Portugal's rules on tax losses, particularly after the changes in the recent Budget, are less generous than in many EU territories. For example Germany, the UK and to a lesser extent France allow a carryback of losses and in Germany and the UK there is no time limit on carryforward, of losses in Portugal losses can only be carried forward 5 years.
It is relatively straight forward for group companies to grant loans to other companies in the group which will generate expenses (interest) and thus reduce profits.
Such a procedure can cause a significant reduction in revenue receipts for the state in which the interest is paid.
Tax authorities have prevented this by imposing limits on the acceptable debt: equity ratio of subsidiary companies (e.g. in the UK where historically 1:1 has been the norm for many companies accepted by the Revenue Authorities). The Portuguese government has opted in the 1995 Budget for legislation allowing thin capitalisation rules based on a ratio of 2:1.
Under the proposed new regime there are a number of major uncertainties to resolve as to how the rules will work in practice.
Given that effective tax rates across the EU vary significantly, even if headline rates do not, it would be preferable for firms operating in more than one country to ensure that profits are earned in the lower tax territory. This becomes even more the case when the group also operates in low tax territories outside the EU. A common means of making profits in one territory at the expense of another is to adjust the price of goods or services between the two territories.
Most EU territories now have rules which stipulate that the tax authorities can adjust prices to arms-length terms for tax purposes between companies of the same group, when it can be stated that such prices differ from those in practice in the market place.
In certain circumstances, these rules merely aim to control prices between companies in different countries, whereas in other cases, as in Portugal, the rules also apply to control transaction prices, independently of whether they are practised on a national or international commercial scale.
The problem is that in practice what amounts to an arms-length price can be highly subjective and can lead to uncertainty in tax treatment.
In recognition of this some Governments are willing to discuss particular transfer prices in advance with taxpayers. The US and certain EU countries have been among the leaders in this. In Portugal, however, it is only possible to secure such agreements in very special circumstances. This is, also, the case in the majority of European countries. It is likely that this will be an area of significant development in the future.
Withholding taxes on dividends, interest, royalties and other payments represent a significant source of income for the Portuguese Treasury and are a relatively efficient means of tax collection. It is for this reason that Portugal has secured a temporary exemption from the EU Parent - Subsidiary Directive. The directive broadly abolishes withholding tax on dividends within the EU but Portugal is to entitled to maintain the withholding tax on dividends until the year 2000. This is currently at a 15% rate until 31/12/96 and thereafter at a 10% rate.
Compared with other EU states this procedure could make Portugal a less attractive country for investment.
Portugal is one of a number of EU territories which is keen to keep withholding taxes on interest, royalties and other payments. Nevertheless it is likely that future pressure will be brought to bear and Portugal will need to consider how long and in what form its withholding taxes can be retained.
Double Tax Treaties
Presently, Portugal has 13 treaties in force, mostly with European countries, and the great majority were signed in the 1960s and 1 970s. It remains of great importance to conclude comprehensive double tax treaties with other trading partners in order to obtain privileged treatment and to stimulate international trade and investment. Progress has however, been slow recently, in part because of the uncertain status of Madeira and in fact one treaty with Denmark has recently been revoked (as from 01/95) because of this issue.
It may be assumed that Portugal will continue to seek to build its tax treaty network over the next few years and it is to be hoped that within a few years the country will have a comprehensive network appropriate for an EU member.
For many years it has been possible for companies to remunerate their employees by non-cash benefits in kind such as company cars, housing and school fees. The trend within the EU has been to bring all such costs into the tax net. In some countries, it is now difficult to provide tax effective benefits at all. This years Portuguese Budget should probably be regarded as merely a stage in this process.
The Portuguese government has chosen to tighten the rules in some areas such as housing costs while taking a more cautious (and less politically sensitive) approach to more widespread benefits such as company cars by disallowing a deduction for the employer rather than taxing the employee. In a similar vein government has sought to stamp out the practice of remunerating employees by "confidential" expenses by increasing the tax surcharge on such expenses for the company to 25% from 10%.
This latter change largely eliminated the tax advantages which existed in the past, since the flat rate will always have to be paid by the company even if it has a tax loss for the year. I believe that we can expect to see further tax changes in future , both in Portugal and the EU, which will effectively treat most forms of remuneration, both in cash and in kind, as subject to tax in the hands of the employee in order to create a tax neutral position.
Stimulations to Saving and Investment
As in previous years the 1995 budget introduced further tax incentives for savings such as the Popular Saving schemes. This type of tax incentive for authorised saving is becoming common in many European territories as a means of encouraging people to plan for their own future. In the long term the Government also encourages investment in company shares and securities as a mean of giving individuals a stake in the success of the economy, in particular through savings participation schemes.
Portugal's tax system is undergoing a process of necessary harmonisation with other EU territories. This process is likely to continue and in doing so it is likely that the system will become more complex as it reacts to and seeks to pre-empt tax avoidance. Unfortunately complexity in tax systems (as evidenced in the US and UK) appears to be an inevitable consequence for mature tax regimes.
The above is based on a article which was first published in Portuguese in the January 1995 edition of Expansao magazine.
For further information please contact Mark Gibbins, tax partner, KPMG Peat Marwick, telephone: +351 1 352 23 77.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about specific circumstances before taking business decisions.
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