Thin capitalization and its practical application in Portugal: a note

Abstract

Purpose

The purpose of this paper is the analysis of an anti‐abuse clause inserted in the Portuguese corporate income tax code (CITC) to deal with some forms of tax avoidance, and the degree of complexity that its practical application can induce for tax payers and tax authorities. The clause is related to “thin capitalization”, and aims at preventing that the financing arrangements between a parent company and its worldwide affiliates can be a source of tax minimization.

Design/methodology/approach

The economic and tax justification for such a clause is presented, and its evolution, in the wake of the European Court of Justice's rulings is discussed. Then, the paper analyses the wording of article 67 and concludes that it can be a source of many doubts for taxpayers, tax authorities and tax courts, when litigation follows from divergent views of firms and tax auditors. The reason for difficulties in the clause's application is the same that plagues many other areas of taxation: there is an established rule, followed by one, or several, exceptions. The paper exemplifies some hypothetical situations that can render the clause applications as quite complex and uncertain.

Findings

The degree of subjectivism of the exceptions established in article 67 can be a source of significant tax complexity. However, being true that numerical rules can be simpler to use, principles make the application of the law to specific situations fairer, by giving courts room for discretion in appreciating each case on its merits, and not being bonded by an explicit rule. The paper argues that a higher level of fairness is worth some degree of complexity.

Research limitations/implications

When managers have to decide on financing plans, especially in multinational contexts, tax implications are at the forefront of relevant issues. Thin capitalization, when established in a way that postulates a rule, followed by exceptions, can render its actual impact in reported income quite ambiguous, given the judgments and technical complexities that can arise in the process.

Originality/value

The paper deals with practical complexities in applying the mentioned clause in the Portuguese CITC. It contributes to the literature by focusing on a micro interdisciplinary analysis – financial, accounting, legal and tax – of an anti‐avoidance mechanism inserted in many tax codes. As such, in every country that has a similar clause, it is at the interplay between law and management, given the potential impact of legal principles and rules in taxable income, corporate tax due, and rates of return.

Citation

Martins, A. (2012), "Thin capitalization and its practical application in Portugal: a note", International Journal of Law and Management, Vol. 54 No. 4, pp. 274-283. https://doi.org/10.1108/17542431211245314