Portugal changes its approach to debt-equity bias following the presentation of the DEBRA proposal

In the wake of the European Commission’s proposal for a Directive to tackle the debt-equity bias in the European Union (“EU”) (“DEBRA”), Portugal has changed its approach to this issue in order to align it with the Commission’s position.

This change comes as a surprise considering that, last November, ECOFIN suspended the analysis of DEBRA until other already announced proposals in the area of corporate taxation are put forward by the Commission (e.g., proposals that bring the BEFIT initiative to life).

Notwithstanding this, the 2023 Portuguese State Budget Law repealed existing tax arrangements aimed at countering the debt-equity bias and introduced a new capitalisation incentive – the Incentive to the Capitalisation of Companies (“ICE”) – which serves the same purpose. Although inspired by DEBRA, these new rules differ from the European proposal in several key respects.

The previous Portuguese approach

Until now, Portuguese law provided for two tax incentives aimed at encouraging the decision to finance through equity rather than through debt: (i) the Conventional Remuneration of Share Capital (“RCCS”); and (ii) the Deduction for Retained and Reinvested Earnings (“DLRR”).

On the one hand, the RCCS allowed companies to deduct a notional interest of 7% on share capital increases of up to EUR 2 million, in the tax year of the increase and in the 5 following tax years. If these increases were reversed and the resulting capital reimbursed to the shareholders, the total deducted amount, increased by 15%, was included in the taxpayers’ tax basis in the year of the share capital reduction.

For companies benefiting from the RCCS, the threshold of the earnings stripping rules was also lower - 25% (instead of 30%) of their tax-adjusted EBITDA.

On the other hand, under the DLRR regime, SMEs were granted a Corporate Income Tax credit of up to 10% of earnings retained and reinvested in the acquisition of certain fixed tangible assets. The amount of retained earnings eligible for this benefit was capped at EUR 12 million for each tax year.

A DEBRA-inspired paradigm shift

Key aspects

The ICE allows companies to deduct 4.5% (or 5% in the case of SMEs and Small Mid Cap companies) of eligible net equity increases each year. This allowance is subject to the higher of the following limits:

⎯ EUR 2 million; or
⎯ 30% of the companies’ tax-adjusted EBITDA. The amount of the allowance exceeding this limit, however, may be carried forward for a period of 5 years.

Similarly to DEBRA, credit institutions, financial companies and other similar entities are not covered by this scheme. In addition, this incentive is also not applicable to companies whose (i) tax and social security obligations are not in order, (ii) taxable profit is determined by indirect methods; and whose (iii) accounting has not been organised in accordance with the accounting standards in force.

For the purposes of this schemes, the following equity increases are considered eligible: (i) cash contributions at the company’s incorporation or in the context of a share capital increase; (ii) share capital increases carried out through the conversion of credits into share capital; (iii) share premiums; and (iv) retained earnings, including those utilized to increase equity reserves or share capital.

Method of application

With regard to the application of the ICE, considering the option for a fixed nominal interest rate (“NIR”), Portugal adopted a simplified system of implementation that largely differs from the one set out in DEBRA. As matter of fact, although the deductible allowance is also determined by multiplying the NIR by the allowance base, the similarities stop there.

Under the Portuguese rules, the total equity allowance to be deducted will be determined annually as whole considering the sum of the net equity eligible increases recorded in each of the previous 9 years, which constitutes the allowance base. The allowance base will be zero whenever this sum’s result is negative.

This system differs from the one proposed in DEBRA which requires the taxpayers to track each year’s increase or decrease in equity on an "individual baskets" approach, and determines the need for positive adjustment to the taxpayer's tax base whenever an equity decrease occurs.

Anti-abuse rules

Under the ICE rules, the following equity increases are not eligible: (i) cash contributions that are indirectly financed by eligible equity increases in another enterprise; (ii) cash contributions made by an associated enterprise which are financed through loans granted by the taxpayer themselves or by a third associated enterprise; and (iii) cash contributions made by an enterprise that is not a resident of a EU Member State, a State of the European Economic Area, or a State with which Portugal has entered into a Double Tax Treaty, a bilateral Tax Information Exchange Agreement (“TIEA”) or a multilateral TIEA.

It is worth noting that the Portuguese rules do not allow the taxpayer to prove that the above-mentioned transactions were carried out for valid commercial reasons and do not lead to a double deduction situation.

Interest deduction

Unlike DEBRA, the Portuguese arrangements do not further limit the deduction of interest, a fact that may result in a significant impact on Portugal’s tax revenues.

Phase-in rules

According to the phase-in rules adopted by the Portuguese legislature, these rules only apply to eligible net equity increases occurring after 1 January 2023.

In light of this, considering that (i) the above-mentioned method of application determines that the allowance base is calculated with reference to the net equity increases registered in the nine previous years (i.e., years N-1 to N-9); and that (ii) when determining the allowance base calculation method, the law makes no reference to the actual year of the calculation and granting of the allowance (i.e., year N), we believe the Portuguese Tax Authority may consider that this incentive will only be granted as of 2024 (although it may not have been the intention of the legislature).

In the absence of any guidance on this point, it is important to monitor any developments on how the Portuguese authorities will interpret this scheme’s phase-in rules.

Teresa Oliveira Braga – Senior Counsel
João Guia Lopes – Trainee lawyer