Tax planning: how to legally minimize Spanish Inheritance Tax by aliens holding Spanish real estate

Posted on Posted in Property Law, Publications, Tax

It is a common situation, that EU citizens, mostly Britons, acquire real estate properties in Spain. In this case, it may be interesting planning ahead of the transmission of these properties in order to minimize the tax costs involved in the succession or sale of them, which can be large.

Let us start with the assumption that the owner of the property is a British citizen which is  non-resident in Spain. In this case, would he like to transfer the property to someone or if he dies and the property passes to his heirs, a large amount of taxes would be due.

One measure that could be adopted in order to minimize taxes, is to contribute the property to a non-resident company in exchange for shares of it. Once contributed, the shares could be transmitted by donation, sold or passed to his heirs without paying taxes in Spain.

The detailed tax implications of this transaction are as follow

Contribution of the Spanish property to a nonresident company

The contribution of the property to a foreign company would trigger the Non Residents Income Tax (“Impuesto sobre la Renta de los No Residentes”). The capital gain would be calculated by the difference between the acquisition cost of the property and the market value of it on the date of the contribution. There is an indexation allowance to account for inflation. The current tax rate is 19 %. It is important to note that “arm’s lenth” rules apply to the transaction, since it is performed between related parties. Therefore, the value of the property should be the fair market value, i.e., the price that would have been paid for it by an informed non related buyer. Obviously, if the property had been bought originally by the nonresident company, this tax would have been avoided. Due to the recent year`s drop in real estate values, the contribution could originate a capital loss if the market value is below the acquisition cost. In this case no tax would be due either.

It seems clear that before embarking in this transaction, the tax payer should seek the advice of a lawyer or tax accountant to calculate the tax cost involved in the contribution. Otherwise he could be facing an upfront tax payment that could exceed his future tax savings.

Tax treatment of the sale of the shares of the Spanish real estate company

According to Article 13, paragraph 4 of the UK-Spain Tax Treaty capital gains arising from the sale of shares can only be taxable in the State in which the seller is resident. Therefore, if the seller is a UK resident he would not be liable to tax in Spain. According to the Tax Treaty, it does not matter the fact that the only asset of the company is a property located in Spain. However, not every Tax Treaty signed by Spain allows this strategy. If the seller is resident in a State other than the UK, the corresponding Tax Treaty must be checked. As said, many Tax Treaties provide rules to prevent the use of this strategy.

Tax treatment in case of donation or inheritance of shares in a Spanish real estate company

According to articles 6 and 7 of the Succession and Donation Tax Act, if both the deceased (or donator) and the heirs are nonresident in Spain, the inheritance would not be subject to Spanish taxes, since the assets actually transferred (the shares) are not from a Spanish company .Even the  General Directorate of Taxes has confirmed this criterion. By contrast, if the alien owner had directly  transmitted the property, he would have been liable in Spain according to the same articles of the law.

Anti-avoidance measures

The first thing to bear in mind is that the measures we are proposing here are under no circumstances tax evasion. There is a precise difference between tax evasion and tax avoidance. Tax evasion implies an intention to avoid payment of tax where there is actual knowledge of liability. It usually involves deliberate concealment of facts from the revenue authorities. It is illegal and frequently entails a criminal offence, i.e. when the taxes unpaid exceed Euro 120.000.

On the contrary, tax avoidance is defined as the arrangement of the taxpayer’s affairs that is intended to reduce his liability which is strictly legal but in contradiction with the intent of the law. The European Court of Justice defined tax avoidance as “artificial arrangements aimed at circumveying tax law”. Some commentators call it “loophole tax plans”.

As one can image, Spanish Law contains several anti – avoidance measures to deal with artificial or fictitious transactions. The most important ones are the rules to fight against:

  1. The abuse of law (called fraus legis),
  2. Sham transactions, also called “cover up” transactions
  3. Wrong characterized transactions

Of course there are as well many specific anti – avoidance measures which target precise or specific types of abuses.

A complete analysis of these provisions clearly goes beyond the scope of this memo but it is important to remark that, in our opinion, the contribution of a property to a foreign company could only be challenged by the “fraus legis” doctrine. According to the Law a transaction can be disregarded for tax purposes when two circumstances arise:

  • The lack of business purpose
  • The artificial test (“substance over form rule”)

Under the business purpose doctrine a transaction must have a commercial justification other than the reduction of tax liability. It is noteworthy saying that when the transaction does have a genuine commercial purpose, the tax payer is entitled to the so called “free choice of the least taxed route”.

The artificial test means that the transactions undertaken by the tax payers must have an economic substance that is coherent with the legal form used by them. When there is a material difference between the legal substance and the economic substance, the transaction (or step transactions) is deemed to be artificial.

In this respect our view is that, from an economic perspective, the disposal of the shares of a company which only owns a single property and that is not engaged in any business activity is equivalent to the sale of such property (the artificial test). Moreover, the incorporation of such company does not seem to have any other purpose but to obtain tax benefits (absence of business purpose). Therefore, the abuse of law rule could be applied by the tax authorities and probably endorsed by the Courts. Thus the tax authorities could take a “look through” approach and disregard the existence of the company, treating the disposal of the shares (either by sale or by inheritance) as if the property itself had been disposed of. In the case of sale, our view is that the Tax Treaty does not allow such treatment, since the look through approach would imply a breach of the Treaty. But for Inheritance Tax the tax payer would not have such a protection.

Finally, it is important to note that when the abuse of law principle is applied, no fines or any other sanctions can be imposed to the tax payer, since he has acted legally (with abuse, though). So the main consequence would be that he could end up paying the Inheritance Tax he wanted to avoid but no more. And a practical consideration is that for the tax authorities to tax the inheritance of the shares they would first have to know that such transfer has taken place. And they have to do so within the term allowed by the statute of limitations (currently, four years). On top of that, the burden of the proof lies with the tax authorities which should provide evidence of the facts supporting the application of the abuse of law rule.