The new rules for Corporation Income Tax (“CIT”) in Spain disallow the deduction of losses resulting from the sale of shares when the tax payer has received tax exempt dividends within a determined look-back period.
According to this rule, the tax deductible loss should be reduced by the amount of tax exempt dividends. As a general rule, dividends obtained from other companies, whether domestic or nonresidents are not taxable in the hands of the parent company as long as it holds at least 5 % of the share capital of the former.
The reasoning behind the rule appears clear. The profitability of an investment must be appreciated after computing all the dividends received during the period of ownership.
For instance, If a company invest 100 in a subsidiary and gets over the years 20 in dividends and finally sells the shares for 70, suffering a loss of 30, the overall result is -10 : (100-70) + 20. If one only focuses on the result of the sale, -30, the scenario would be somehow distorted.
As taxes are concerned, since the dividends would normally be exempt, the deduction of the full loss on the sale would imply an artificial erosion of the taxable base. For tax purposes, the tax payer would have been allowed to deduct 30, while the actual loss is only 10.
For that reason, in cases where the dividends are taxable, for example, dividends from a company in which the shareholder owns less than 5 %, the law allows the full deduction of the loss suffered on the sale of these shares. If not, the tax payer would experience an extra taxation.
Finally, in some circumstances the accounting rules establish that dividends received must not be treated as income but reduce the cost of the investment. Although such dividends are not taxable, the law allows in this case the deduction of the full loss of the sale. The reason is that in these cases, the dividends themselves have already reduced the accounting loss, so no further measure is needed. For instance, a company invests 100 in shares and receives 20 in dividends corresponding to earnings of prior years. The accounting rules oblige to treat such dividends as a reimbursement of the investment. Then the tax and accounting base of the investment would be 80. If the owner sells the shares for 70, suffering a loss of 10, this loss would be fully deductible for tax purposes.
The look back period for the dividends in the law is 2009. In other words, dividends received before that date are completely disregarded as this rule is concerned. This exception has not any technical background, but a legal basis. When this rule was approved, the oldest year that was open to a tax audit was 2009 so, theoretically, the tax payers were not obliged to keep records of previous years.
Generally speaking, the tax treatment of the losses on the sale of shares when the tax payer has received dividends from these shares is fair. It tends to equalize the tax deduction to the actual loss experienced, avoiding an artificial erosion of the taxable base.