Exemption versus foreign tax credit relief

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How to avoid double taxation on foreign source dividends

In Spain, double taxation of foreign source dividends can be avoided by the two classic system: the participation exemption or the foreign tax credit relief (i.e. the imputation system). The exemption system is applicable under certain conditions, namely, a participation in the foreign subsidiary of, at least 5 % and a minimum underlying nominal tax at the foreign sub level of, at least, 10 %.

Read more: The participation exemption system in Spain

Where the exemption system is not applicable, the imputation system can be applied (for instance, where the underlying tax is lower than 10 %). Note that even if the exemption system would be applicable, the tax payer can always waive the application of the exemption and opt for the imputation system. As we all know, when the tax paid by the subsidiary is equal or higher than the Spanish Corporation Tax rate – currently 25 %- both systems lead to the same practical outcome: no additional taxes are to be paid in Spain. On the contrary, when the tax at the subsidiary level is lower than the Spanish tax rate, the imputation system would trigger additional taxation in Spain, being the difference between the tax paid by the subsidiary and the Spanish tax rate. In this latter scenario, it is clear that the exemption system would be preferable.

The above conclusions are generally boiled down to one simple rule: exemption is always a better system to avoid double taxation from the tax payer’s view-point.

It is always better the exemption system than the imputation system?

Well, not quite. At least with the current rules in the Spanish Corporation Tax.

Of course we are interested in the scenario where the tax paid by the subsidiary is higher than the Spanish Corporation Tax rate. As stated before, in this scenario both systems lead to the same outcome. Let us see a simple example:

A company with operating  profits of 300 has received net foreign dividends of 140. The underlying tax (i.e. the Corporation Tax paid by the subsidiary in his home country is 30 % or 60). Thus, the calculation of the Spanish Corporation Tax would be as follows:

Exemption Imputation
Operating profit              300           300
Foreign dividend – grossed up-                –           200
Taxable base              300           500
Gross tax payable (25 %)               75          125
Foreign tax credit (1)                –             50
Tax liability               75             75

 

(1) Only 25 % of the underlying tax is creditable. No matter that the foreign sub paid more (30 %).

In this scenario then we could come up to the conclusion that it matters very little which method the tax payer applies. But in many cases, applying the exemption would be a wrong and costly choice. This is due to the fact that several tax allowances stablished in the law have a limit linked to the taxable base. The most important ones are the tax loss relief and the allowance reserve for undistributed profit (the capitalization reserve).

The tax loss relief only allows the tax payer to offset prior year’s losses up to the 70 % of the taxable base. Likewise, the capitalization reserve allowance is limited to the 10 % of the taxable base.

Read more: tax loss relief

Read more: reduced tax rate for reinvested profits

Since these two incentives are linked to the taxable base, it is obvious that the higher the taxable base the higher the tax benefit that can be applied. Therefore, the imputation system should be preferred, since foreign source dividends would increase the taxable base, but will not trigger any additional taxation because of the foreign tax credit relief.

Worked example

The basic assumptions for this example is that the company has prior years offsetable losses of 500 and has received net foreign dividends of 140. The underlying tax (i.e. the Corporation Tax paid by the subsidiary in his home country is 30 % or 60). Therefore, the gross dividend is 200.

Based on these assumptions, the Spanish Corporation Tax for 2016 would be calculated as follows for the two possible scenarios: the participation exemption system and the imputation (tax credit) system. In this latter system note that the maximum tax credit allowed would be 25 % of the foreign dividend and not the 30 % underlying tax.

 

Exemption Imputation
Operating profit              300           300
Foreign dividend – grossed up                –           200
Preliminary Taxable base              300           500
Tax loss relief (60 %)              180           300
Taxable base             120          200
Gross tax payable (25 %)               30             50
Foreign tax credit                –             50
Tax liability               30             –

 

As can be easily deducted from the above example, the imputation system would clearly be a wiser choice because it allows the tax payer to anticipate the application of the tax loss relief, reducing the current year’s tax liability.

Contributed by Emilio Alvarez: ealvarez@lexcam.com.es