Tax changes shift focus to consolidation

Author: | Published: 1 Sep 2005
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In recent years, the Portuguese tax rules related to mergers and acquisitions have been changed to tackle transactions with little or no economic substance other than tax avoidance. But in many cases these amendments have disturbed the normal course of business in legitimate transactions and have been imposing an unjustified compliance burden on taxpayers.

Unfortunately, tax avoidance seems to have been the legislator's sole concern when drafting these rules, at a time where a boost to corporate reorganizations is much needed. The legislation was generally not amended to provide guidance on the substantial unresolved issues related to mergers and acquisitions of companies in Portugal.

Naturally, anti-avoidance provisions are necessary in any tax system. However, the Portuguese parliament and government have too often resorted to blind rules, presuming tax avoidance motivation in transactions that are typically entered into for valid economic reasons. This has slowed down corporate reorganizations in Portugal.

The most relevant amendments were as follows:

  • Firstly, the tax consolidation regime was extended to the total profits of the group (before, tax consolidation was only allowed on 65% of the group's profits).
  • Parliament passed several new rules related to the deductibility of tax losses in the context of corporate reorganizations. Losses are totally disallowed if most of the company's share capital was transferred. The tax authorities have issued several rulings limiting the deductibility of losses in the context of mergers.
  • The holding company's tax regime was modified, denying interest deductions on loans obtained to acquire participations in qualifying subsidiaries.
  • Lastly, the rules that allowed exemptions for indirect taxes in corporate reorganizations have been limited this year, which will most certainly also have an adverse impact on mergers and acquisitions in Portugal.

These recent changes have a substantial bearing on the structuring of business and the acquisition of Portuguese companies by foreign investors.

Traditionally acquisitions have been structured using Portuguese vehicles, usually companies, with the purchaser contributing the necessary funds for the acquisition. These companies would then acquire either the assets or the stock of Portuguese targets. Acquiring assets has the advantage of sheltering the acquirer from most of the target's previous liabilities and increasing the tax basis on the acquired assets. Acquiring stock is generally simpler from a transaction implementation standpoint and usually results in a lower taxation for the seller.

The recent developments in Portuguese legislation have mostly affected stock acquisitions.

Stock acquisitions generally

If the stock in a corporation, and not its assets, is to be acquired and if the target is not publicly traded, the buyer may simply purchase the target stock. Publicly traded companies can be acquired by tendering for the stock, which raises a number of other problems that will not be analyzed here.

However, most of the time the purchaser wishes some acquisition indebtedness to be incurred, and it is common practice to incorporate a Portuguese vehicle for this purpose. This vehicle is funded with equity and debt. Customarily, the vehicle and the target are at a certain point merged into a single entity. This allows for the interest deduction on the acquisition debt to be deductible against the profits arising from the target's activities.

Merging the target and vehicle

For several years, the only alternative to deducting acquisition interest expense against the target's taxable income was to merge both entities into a single entity (as depicted in Diagram 1). In theory, there are three ways to implement this merger: (i) the target is merged into the vehicle (upstream merger); (ii) the vehicle is merged into the target (downstream merger); or (iii) both are merged into a new entity (this is almost never used in the context of leveraged acquisitions). Portuguese legislation does not allow cash mergers.

Diagram 1

According to domestic legislation, in principle and provided certain requirements are met, mergers can be eligible for tax neutrality. According to the tax-neutrality regime, gains arising from the transaction will not be subject to tax. Rather, the acquiring company registers the acquired assets in its tax books for the same value that the assets were registered for in the transferor's books. On a future transfer of the assets, the tax authorities will be able to impose income tax on all the built-in gains.

In theory, the downstream merger (in which the target is the surviving entity) would be the most convenient option, for the following reasons:

  • Although mergers might be eligible for tax neutrality for income tax purposes, they are nevertheless subject to several indirect taxes. These include real estate transfer tax and stamp duties. Naturally, these taxes will not be triggered if the vehicle is the absorbed entity, because it will not hold any assets subject to these taxes.
  • A downstream merger avoids all the hurdles of an upstream merger, in particular registry cancellation, assignment of contracts and all other compliance issues related to the transfer of the target's assets to the vehicle.
  • In a downstream merger, the deduction of the target's losses would not be put at risk. In an upstream merger, the deduction of previous losses is dependent on a special authorization by the Ministry of Finance.

However, recent developments have been casting some doubts and concerns on such transactions. According to the Portuguese tax authorities' recent informal opinion, a downstream merger by nature does not qualify for tax neutrality. This means that any gains arising from the transaction will be immediately taxed. Although the position (informally) taken by the tax authorities seems totally inappropriate, it has not yet been challenged in any tax courts.

Also, one of the main advantages of a downstream merger was the possibility to carry forward the target's tax losses. However, parliament has just passed a new provision limiting the loss carry-forward to companies in which most of its capital was transferred to a new shareholder. Therefore, in cases where the merger was preceded by an acquisition, the losses of the acquired entity are already lost in the acquisition and it is unnecessary to secure its deduction on the subsequent merger.

The second merger option (the upstream merger, where the vehicle is the surviving entity) is less used not only because it is more complicated from a compliance standpoint but also because it is harder to secure the tax deduction of the target's losses. These difficulties were increased by recent rulings issued by the tax authorities, but are no longer relevant because the target's losses will be disallowed anyway by virtue of the preceding acquisition of the target's stock by the vehicle.

Lastly, the biggest concern for tax practitioners in mergers is the transaction's economic substance. One of the requirements for applying the tax-neutrality regime is that the transaction must be entered into for valid economic reasons. Based on this rule, there is a risk that the tax authorities will challenge the tax neutrality of mergers in which there is little economic substance other than to deduct interest expense for tax purposes.

As a result, in leveraged acquisitions, merging the vehicle with the target is progressively losing its appeal against maintaining both as separate entities after the acquisition. The use of the target's losses is no longer a concern, because they will most likely be lost in the acquisition of the target's stock. Furthermore, downstream mergers are (in the recent opinion of the tax authorities) not eligible for tax neutrality. However, upstream mergers are usually too complicated to be implemented. Lastly, the economic substance requirement is always an additional problem in both cases.

Filing consolidated returns

Maintaining both the vehicle and the target as separate entities after the leveraged acquisition has some interesting advantages from a tax perspective.

Before January 2001, Portuguese law did not allow groups of companies to file a full consolidated return. The group's tax basis had to be at least 65% of the income that would have been taxable if the companies were not within the tax group.

At this moment in time, however, full consolidation is allowed. As a rule, Portuguese companies holding, directly or indirectly, at least 90% of the share capital and at least 50% of the voting rights of companies resident in Portugal for tax purposes may file a consolidated return for the whole group. Under this regime, a group company's expenses may be deductible against income from the other group entities.

Therefore, in practice, interest paid by the vehicle (if not a SGPS as further explained below) will effectively be deductible against the target's income for tax purposes. The mechanics are as follows: the target will generate profits that would naturally be added to the consolidated taxable income; the vehicle, on the other hand, will have an interest deduction against that same taxable basis (see Diagram 2).

Diagram 2

Since 2001, several limitations have been introduced in the tax-group regime, mostly targeting the inclusion in the tax group of inactive companies, or companies that have generated losses in all of the previous three fiscal years.

Naturally, these limitations have little impact on leveraged acquisitions of Portuguese companies by foreign investors. Typically, in these acquisitions, the vehicle is a newly incorporated entity and as such the above limitations would not apply.

The main problem to deal with in consolidating companies involved in leveraged acquisitions is the timing requirement imposed by the Portuguese consolidation regime. To begin with, companies may only file consolidated returns if the corporate structure has been in place for at least 12 months on the beginning of the fiscal year. This waiting period can be extended to two years if the target has losses in all of the previous three fiscal years.

If these issues are not dealt with, the tax deduction of interest in the two-year period immediately after the acquisition might be lost.

Although there might be several downsides to using consolidation (most of these resulting directly from rules in the purchaser's jurisdiction, the increased compliance work – which most of the time is not relevant – or delays on dividends distributions – interim dividends are limited under Portuguese corporate legislation) from a Portuguese tax perspective, it is generally advantageous to hold participations through a holding vehicle. In particular, filing tax-consolidated returns is a fairly straightforward method of deducting interest expense against profits of target companies in leveraged acquisitions. Also, it does not give rise to economic substance issues that emerge if the vehicle and the target are merged.

Holding company regime

Furthermore, there may be several other advantages of holding stock in Portuguese operating companies through a double company structure. However, these structures must be carefully planned, because several rules impose limitations on these benefits.

In general, the vehicle (holding company) can either be a pure holding company (sociedade gestora de participações sociais – SGPS) or a company with a normal commercial activity that additionally holds stock in a subsidiary. In theory, if a company has pure holding activities it should be incorporated as an SGPS.

There are not many differences in the taxation rules applicable to SGPS and regular companies holding substantial participations in Portuguese entities. However, two of the main differences in the regimes are extremely relevant, as follows:

  • A SGPS may not deduct any interest on funds borrowed to acquire participations that qualify for the Portuguese participation exemption. This limitation does not apply to regular companies holding stock in other Portuguese entities.
  • The SGPS regime exempts capital gains from the transfer of participations in Portuguese and EU entities. Capital gains from such transfers by regular companies are taxed at the general rate of 27.5%.

Therefore, in the case of leveraged acquisitions, careful planning should be used to avoid using a SGPS. The capital gains downside is limited by the fact that, in most cases, a foreign investor selling the stock of the holding company would not be subject to Portuguese tax on the gain.

One efficient planning technique in leveraged acquisitions is for the acquisition vehicle to acquire part of the target's assets and use them for carrying out economic activities (see Diagram 3). The core business would still be carried out by the target. With proper planning this transaction would not trigger any stamp duties.

Diagram 3

This strategy effectively avoids the characterization of the vehicle as a SGPS, because it will carry out activities other than holding stock. Also, with this strategy losses can be used that would otherwise be lost by the target, because the transfer of the target's stock will automatically disallow any carry-forward of previous losses. However, the gains from the transfer of assets previously to the acquisition of the target's stock can be sheltered from tax against the target's tax losses. Conversely, the vehicle would acquire the assets on a high tax basis, which will result in substantial depreciation allowances being deducted against the vehicle's business income.

The appeal of consolidation

At present and in the context of leveraged acquisitions, there are two ways to use acquisition interest against the target's taxable income. These options are: merging the acquisition vehicle with the target or keeping both entities separate and filing a consolidated tax return.

Traditionally, the merger method was more frequently used. However, recent developments in Portuguese tax legislation have made the consolidated group option more attractive and also have imposed several limitations on merging that reduced its appeal. Additionally, despite some evident drawbacks, using a tax group offers some interesting tax-planning opportunities.

Author biographies

Diogo Ortigão Ramos

Gonçalves Pereira, Castelo Branco & Associados

Diogo Ortigão Ramos is head of the tax practice group and has been a partner of the firm since 2000. His main areas of practice include general tax advice to domestic and multinational companies, domestic and international tax planning, transaction structuring (mergers and acquisitions, buyouts and multinational group reorganizations), tax planning for individuals, family-owned businesses and corporations, taxation of real estate investments, taxation of financial instruments and tax litigation.

He has recently advised on the financing of Portuguese Motorways Network for €570 million and financing Railway Network for €600 million; the acquisition of a domestic construction group by a Spanish real estate group for €160 million and the acquisition of two Portuguese business groups by one of the biggest US private equity companies; the financing of a real estate investment fund in the total amount of €1 million; tax planning for Portuguese investments in real estate projects in Brazil, infrastructure investments in Venezuela, and several Portuguese investments in Spain; and the reorganization of the international holding structure for one of the largest utilities groups in Portugal.

Diogo Ortigão Ramos graduated from Universidade Lusíada Law School in 1989. He holds a post-graduation qualification in tax law from Instituto Superior de Gestão. He was admitted to the Portuguese Bar in 1989.

He is a member of the Portuguese Bar, the International Bar Association, and the International Fiscal Association.

António Rocha Mendes

Gonçalves Pereira, Castelo Branco & Associados

António Rocha Mendes's main areas of practice include domestic and international tax planning advice to Portuguese and foreign-based multinational companies and tax advice on corporate reorganizations.

In the last few years, he has worked on the financing of Portuguese Motorways Network for €570 million and the financing of Railway Network for €600 million; the acquisition of a domestic construction group by a Spanish real estate group, worth €160 million and the acquisition of two Portuguese business groups by one of the biggest US private equity companies; tax planning on investments by Portuguese groups in real estate projects in Brazil, infrastructure investments in Venezuela, and several Portuguese investments in Spain; and the reorganization of the international holding structure for one of the largest utilities group in Portugal and the restructuring of an industry multinational group with participations in nine countries spread over three continents.

António Rocha Mendes graduated from Universidade Católica Law School in 1993. He holds a post-graduate diploma in tax law from Instituto Superior de Gestão. He was admitted to the Portuguese Bar in 1993. Mendes also holds an LLM from Boston University School of Law (1999) and has practised in New York (1999 to 2001), Brazil (2002) and Spain (2002 to 2004).

He is a member of the Portuguese Bar, the International Bar Association, and the International Fiscal Association.