Process: 283/2017-T

Date: November 21, 2017

Tax Type: IRS

Source: Original CAAD Decision

Summary

This CAAD arbitration decision (Process 283/2017-T) addresses whether Portuguese tax residents can claim a tax credit for US state income tax under Article 81 of the CIRS. The taxpayers earned income in the USA in 2010 and paid both federal and state taxes totaling USD 7,243.20 in state tax. The Portuguese Tax Authority denied the tax credit for state taxes, arguing that since the Portugal-US Double Taxation Convention exists, Article 81(2) CIRS applies, and because state taxes are not listed in Article 2 of the Convention, no credit is available. The taxpayers contested this, asserting that Article 81(1) CIRS should apply instead, as it covers situations where taxes are not covered by double taxation conventions. The core legal issue centers on the interpretation of Article 81 CIRS: paragraph 1 applies when no convention exists or when taxes fall outside the convention's scope, while paragraph 2 applies to taxes expressly covered by conventions. The taxpayers argued that since the Contracting States (Portugal and USA) deliberately excluded state taxes from the Convention's scope, such taxes should be regulated by domestic legislation under Article 81(1), which aims to protect taxpayers from double taxation in situations not addressed by treaties. The Tax Authority maintained that the mere existence of a convention triggers Article 81(2), regardless of whether specific taxes are covered. This case has significant implications for Portuguese residents with US-sourced income subject to state taxation, as it determines whether they can obtain relief from double taxation on state-level taxes not contemplated in the bilateral treaty.

Full Decision

ARBITRAL DECISION

REPORT:

A…, NIF … and his wife, B…, NIF…, residents at Rua …, nº…, …, …-… Póvoa de Varzim, hereinafter referred to as Claimants, filed a request for constitution of an arbitral tribunal in tax matters and a request for arbitral pronouncement, pursuant to the provisions of paragraph a) of no. 1 of article 2 and paragraph a) of no. 1 of article 10, both of Decree-Law no. 10/2011, of 20 January (Legal Regime for Arbitration in Tax Matters, hereinafter briefly referred to as RJAT), petitioning the declaration of partial illegality of the IRS assessment number 2014…, relating to the fiscal year 2010, in the total amount of € 25,651.27, as well as the condemnation of the Respondent to the payment of indemnifying interest.

To substantiate their request, they allege, in summary:

  • The Respondent proceeded to correct the values declared by the Claimants, relating to income earned by the Claimant in the USA, as well as the tax paid in the USA;

  • Such correction originated from the fact that the Respondent did not recognize the right to tax credit resulting from state tax paid in the USA, in the amount of USD 7,243.20, which, at the exchange rate at the end of 2010, corresponded to € 5,420.75;

  • The non-recognition of this right stems from the fact that, according to the Respondent, given the existence of a Double Taxation Convention entered into between Portugal and the USA, the rule provided for in article 81, no. 2 of the Personal Income Tax Code (CIRS) must be resorted to;

  • And, also according to the Respondent, with state tax paid by the Claimant not being provided for in article 2 of the Convention, it cannot be subject to tax credit under the terms of article 81, no. 1 of the CIRS;

  • To the contrary, however, of what is defended by the Respondent, to the situation in this case no. 2 of article 81 of the CIRS is not applicable, but no. 1;

  • Only no. 2 of this article is applicable in relation to taxes contemplated in the respective conventions, which is not the case of state tax paid in the USA;

  • It was the Contracting States themselves (Portugal and USA) who opted not to apply the rules established in the Convention to state tax, and consequently, such matter should be regulated in accordance with the provisions of their respective internal legislation;

  • The national legislator, in article 81, no. 1 of the CIRS, intended to protect the taxpayer from situations of double taxation not provided for in the conventions or in which it could not be applied;

  • The Claimants filed a gracious objection against the assessment in question in the present case, and it was denied.

The Claimants attached 9 documents and did not list any witnesses.

In the request for arbitral pronouncement, the Claimants opted not to appoint an arbitrator, and therefore, pursuant to the provisions of article 6, no. 1 of the RJAT, the undersigned was appointed by the Deontological Council of the Administrative Arbitration Center, and the appointment was accepted in accordance with legal provisions.

The arbitral tribunal was constituted on 30 June 2017.

Notified in accordance with and for the purposes of the provisions of article 17 of the RJAT, the Respondent filed a reply, invoking in summary:

  • From the analysis of article 81 of the CIRS, it results that the regime provided for in no. 1 applies to cases where there is no convention entered into between Portugal and the State of source of income;

  • On the contrary, in cases where there is a convention entered into between Portugal and the State of source of income, the rule contained in no. 2 of said article applies;

  • In the case of this matter, there is a convention entered into between Portugal and the USA, State of source of income, and therefore the rule provided for in no. 2 of article 81 of the CIRS must be applied;

  • The dichotomy between federal and state taxes in the USA already existed at the time the convention was entered into;

  • Whereby it was the intention of the Contracting States to preclude the possibility of tax credit in cases of tax borne not referring to the Internal Revenue Code, namely state taxes;

  • State tax paid by the Claimant in the USA not being covered by article 2 of the Double Taxation Convention entered into between Portugal and the USA, it cannot be subject to tax credit under the terms of the provisions of article 81, no. 2 of the CIRS.

It concludes, petitioning the dismissal of the request for arbitral pronouncement.

The Respondent attached a copy of the administrative file and did not list any witnesses.

Given the position assumed by the parties and there being no need for additional production of evidence, the holding of the meeting referred to in article 18 of the RJAT was dispensed with, as well as the presentation of arguments.

PRELIMINARY DETERMINATION:

The Arbitral Tribunal was regularly constituted and is materially competent.

There are no nullities that invalidate the proceedings.

The parties have legal personality and capacity and are legitimate, with no defects in representation.

There are no other nullities, exceptions or preliminary issues that prevent the determination of the merits and which it is necessary to address ex officio.

MATTER TO BE DECIDED:

Given the positions assumed by the Parties, it is verified that the sole matter to be decided is whether, given the fact that state tax paid in the USA is not provided for in article 2 of the Double Taxation Convention entered into between Portugal and the USA, this state tax can be deducted from the tax payable in Portugal, under the terms of the provisions of article 81, no. 1 of the CIRS.

FACTUAL FINDINGS:

Facts Proven

With relevance to the decision to be rendered in the present case, the following facts were established:

  • By official letter dated 29/09/2014, the Claimants were notified of the following alterations to Annex J of the model 3 income statement filed by the Claimants relating to the fiscal year 2010:

    • Income earned in the USA, corrected to the amount of € 104,233.64;
    • Tax paid in the USA, corrected to the amount of € 22,203.26;

  • The alteration relating to tax paid stems from the difference between federal tax and state tax paid by the Claimant in the USA, given the fact that the Respondent did not recognize to the Claimants the right to recognition of tax credit for state tax paid by the Claimant in the USA;

  • Following this, the Claimants were notified of the disputed assessment note, from which resulted a tax payable in the amount of € 25,651.27;

  • The Claimants filed a gracious objection against the disputed assessment, which was denied by official letter dated 13/01/2017;

  • The request for constitution of the arbitral tribunal in tax matters and for arbitral pronouncement was filed on 21/04/2017;

  • The Claimants paid the tax now in dispute.

Facts Not Proven

Of interest to this case, no other fact was proven.

Basis of Factual Findings

The conviction regarding the facts established as proven was formed on the basis of the documentary evidence attached by the Claimants, indicated in relation to each point, whose correspondence to reality was not questioned, as well as the administrative file attached by the Respondent and the matter alleged and not disputed.

ON THE LAW:

With the factual findings established, it is now necessary to determine the applicable law.

At issue in the present case is state tax paid by the Claimant, relating to income earned by him in the USA in the fiscal year 2010, in the amount of USD 7,243.20, which, at the exchange rate at the end of 2010, would correspond to € 5,420.75 and the lack of recognition, by the Respondent, of the right to tax credit in the same amount.

The reasons presented by the parties in defense of their thesis are summarized in few words.

The Respondent understands that, given the existence of a Double Taxation Convention entered into between Portugal and the USA, the regime provided for in the respective convention is applicable to taxes on income paid in this territory.

However, as the convention in question does not provide for any right to recognition of tax credit for state tax paid in the USA, then the regime provided for in article 81, no. 2 of the CIRS will be applicable, and the regime provided for in no. 1 of the same article cannot be applicable for the simple reason that, in this case, there is a Double Taxation Convention entered into between the States in question.

On the contrary, the Claimants argue that, as the Double Taxation Convention entered into between Portugal and the USA does not provide for its application to state tax, everything will proceed as if, after all, there were no convention whatsoever.

Thus, to this tax the regime provided for in article 81, no. 1 of the CIRS will be applicable since, although there is a Double Taxation Convention, it is not applicable to the tax in question.

Let us examine this.

As is known, in Portuguese tax law the principle of universality of taxation of individuals and legal entities prevails, and article 15 of the CIRS prescribes that, where individuals are resident in Portuguese territory, IRS is levied on all of their income, including that obtained outside such territory.

However, in situations where income obtained, that is, where the taxable event comes within the scope of two distinct tax rules, giving rise to an accumulation of tax claims[1], it is necessary to reconcile these two claims, so as to avoid double taxation.

Double taxation constitutes a positive conflict of taxation and may be economic or legal double taxation.

Economic double taxation, which may or may not be international, occurs when the same income is subject to taxation in the sphere of two different taxpayers.

In turn, legal double taxation occurs when the same income, relating to the same tax period, is subject to the same tax, in the sphere of the same taxpayer, coming from two different tax systems.

This double taxation is always international, and there is no possibility of legal double taxation existing within the same legislation.

Legal double taxation thus presupposes the identity of the taxable event and the plurality of tax rules belonging to distinct legal-tax systems[2].

The identity of the taxable event requires, in turn, that between two or more taxations there is identity of object, identity of subject, identity of tax period and identity of tax, with identity of tax existing when in both systems the tax has identical substantive nature[3].

Given this,

International double taxation constitutes a constraint on investment and economic development, affecting the free movement of persons, goods, services and capital.

In order to eliminate, avoid or mitigate double taxation, States have two mechanisms at their disposal: unilateral measures, contained in provisions of internal law, and bilateral measures, contained in international double taxation conventions.

Unilateral measures are internal mechanisms for elimination of international double taxation adopted by each State without the necessary correspondence in other legal systems[4], and may consist of an exemption – integral or progressive – from tax, with income obtained abroad being exempt from tax in the State of residence, where it is taxed exclusively; or a deduction of tax paid in the State of source from the tax payable in the State of residence.

In the case of income earned by individuals, the deduction from the tax liability with a view to eliminating double taxation may be effected in one of the following forms:

  • Either through an internal unilateral measure, consisting of the granting of a deduction from tax liability (article 81, no. 1 of the CIRS);

  • Or through a convention to eliminate double taxation (article 81, no. 2 of the CIRS).

Indeed, under the heading "elimination of international double taxation", no. 1 of article 81 of the CIRS, in the wording in force at the date of the facts, prescribed:

"Holders of income of different categories obtained abroad have the right to a tax credit for international double taxation, deductible up to the amount of the tax liability proportional to such net income, considered in accordance with the terms of paragraph b) of no. 6 of article 22, which will correspond to the lesser of the following amounts:

  • Income tax paid abroad;

  • Portion of the IRS tax liability, calculated before the deduction, corresponding to income that in the country in question may be taxed, net of specific deductions provided for in this Code."

In turn, pursuant to the provisions of no. 2 of the same article, "where there is a convention to eliminate double taxation entered into by Portugal, the deduction to be effected under the terms of the previous number cannot exceed the tax paid abroad under the terms provided for by the convention.

From the reading of these provisions it results that the regime provided for in no. 1 is the standard regime to be applied with a view to eliminating or mitigating international double taxation of tax paid in the State of source that is not provided for in any Double Taxation Convention. In turn, the regime provided for in no. 2 is nothing more than the fixing of a limit to that deduction, applicable to taxes in relation to which a Double Taxation Convention has been entered into.

With regard to bilateral methods for avoiding double taxation, it is important to consider the content of the Convention entered into on 06/09/1994, between the Portuguese Republic and the United States of America to Avoid Double Taxation and Prevent Fiscal Evasion with Respect to Taxes on Income.

Such Convention was ratified on 21/06/1995, having been published in the Official Gazette (Diário da República) on 12/10/1995.

As expressly results from article 1 of said Convention, it applies to persons who are residents of one or both Contracting States, unless the Convention provides otherwise.

Pursuant to article 2 of said Convention, it applies to the following taxes:

  • In Portugal: to IRS, IRC and local surcharge;

  • In the United States of America: (i) federal taxes on income imposed under the provisions of the Internal Revenue Code (General Tax Code), excluding contributions for social security and (ii) special tax relating to investment income of private foundations, under section 4940 of the Internal Revenue Code (General Tax Code).

It is thus verified, without any room for doubt, that, regarding taxes paid in the USA, the Convention entered into does not apply to state taxes but only to federal taxes on income provided for in the Internal Revenue Code and the special tax relating to investment income of private foundations.

Moreover, regarding the non-application of the Double Taxation Convention to state taxes, at issue in the present case, there is consensus between the Claimants and the Respondent.

The point of disagreement lies in the application of unilateral measures to avoid international double taxation provided for in article 81, no. 1 of the CIRS, given the fact that state taxes are not provided for in the convention entered into.

As already stated above, we are of the understanding that the rule provided for in no. 1 of article 81 of the CIRS applies to taxes paid in the State of source that are not provided for in any Double Taxation Convention.

Note that taxes may not be provided for in any Double Taxation Convention because purely and simply no Convention has been entered into between the State of source and the State of residence or because, although a Convention has been entered into between these two States, the parties did not intend to cover that specific tax in the regime provided for to avoid double taxation.

This is, in our view, the best interpretation of the provisions of article 81 of the CIRS.

In fact, although there is a Convention entered into between the State of source and the State of residence, one must necessarily contemplate that no Convention exists when taxes not provided for in that same Convention are at issue.

In these cases, one must resort to the unilateral measure for elimination of double taxation provided for in article 81, no. 1 of the CIRS.

This is precisely the case of state taxes paid in the United States of America.

In fact, these taxes not being enshrined in the Double Taxation Convention entered into between Portugal and the USA, their taxation must be carried out by resorting to the application of unilateral measures provided for internally, and one cannot resort, for the purpose of taxation of these taxes, to the Convention entered into between the USA and Portugal for the simple reason that such Convention does not provide for any regime to avoid double taxation in relation to these taxes.

But the fact that the Convention does not provide for such a regime does not mean that, with regard to these taxes, it is not necessary to avoid double taxation.

Note that, contrary to what is alleged by the Respondent, the fact that these state taxes already existed at the time the Convention was entered into does not mean that the parties intended not to include them in the tax credit mechanism.

On the contrary, such fact is merely revelatory of the fact that the contracting parties did not intend to subject those taxes to the regime of the Convention, subjecting them only to the unilateral measures for prevention of double taxation adopted by the State of residence, since it is to this State that the competence to eliminate international double taxation pertains.

Equally, it is true that, pursuant to the provisions of article 7, no. 3 of the Civil Code, general law does not repeal special law, as invoked by the Respondent.

But in the case of this matter no repeal of special law by general law is verified.

In fact, in this case, the special law (Double Taxation Convention entered into) does not provide for any regime applicable to state taxes, and therefore one must necessarily resort to the general law (internal rules) to eliminate or mitigate double taxation.

In light of all that has been stated, given that the Claimants paid state tax in the United States of America and this tax is not applicable to the Double Taxation Convention entered into between Portugal and the United States of America, they have the right to recognition of a tax credit, by way of the application of the provisions of article 81, no. 1 of the CIRS.

Thus, it is clear that there is no legal basis for the assessment issued, in the disputed part, and therefore its partial annulment is imperative.

Finally, the Claimants also petition the condemnation of the Respondent to the payment of indemnifying interest counted from the date of payment of the tax until the date of its full reimbursement.

Regarding indemnifying interest, article 43, no. 1 of the General Tax Law (LGT) prescribes that "indemnifying interest is due when it is determined, in gracious objection or judicial challenge, that there was an error attributable to the services from which resulted payment of the tax debt in an amount greater than legally due."

In the case now under examination, the error affecting the disputed assessments and whose illegality has been declared is attributable to the Tax Authority, and therefore there is no doubt that the Claimants have the right to receipt of indemnifying interest.

In this case, interest will be due from the date of payment of the tax, given the fact that it was not due to any reason attributable to the taxpayer that the Respondent issued the disputed assessment.

OPERATIVE PART

In light of the foregoing, it is decided:

  • To uphold the request for declaration of partial illegality of the disputed assessment, with the consequent partial annulment of such IRS assessment act;

  • To condemn the Respondent to reimburse to the Claimants the amount of € 5,420.75;

  • To condemn the Respondent to pay to the Claimants indemnifying interest, calculated on the amount of € 5,420.75, at legal rates, from the date of its payment until effective and full reimbursement by the Respondent.

The value of the case is set at € 5,420.75, pursuant to the provisions of paragraph a) of no. 1 of article 97-A of the Tax Procedure and Process Code, applicable by force of paragraphs a) and b) of no. 1 of article 29 of the RJAT and no. 2 of article 3 of the Regulation of Fees in Tax Arbitration Processes.

The amount of the arbitration fee is set at € 612.00, pursuant to Table I of the Regulation of Fees in Tax Arbitration Processes, as well as no. 2 of article 12 and no. 4 of article 22, both of the RJAT, and no. 4 of article 4 of the aforementioned Regulation, to be paid by the Respondent, as the unsuccessful party.

Register and notify.

Lisbon, 21 November 2017.

The Arbitrator,

Alberto Amorim Pereira

Text prepared by computer, pursuant to no. 5 of article 131 of the Code of Civil Procedure, applicable by reference of paragraph e) of no. 1 of Decree-Law no. 10/2011, of 20/01.

[1] PAULO ROSADO PEREIRA, "Principles of International Tax Law – from the Classical Paradigm to European Tax Law", Almedina, 2010, pp. 22 and 23

[2] AMÉRICO BRÁS CARLOS, "Taxes – General Theory", Almedina, 2016, page 208.

[3] AMÉRICO BRÁS CARLOS, op. cit. loc. cit.

[4] Cfr. ARMÉNIO BRÁS CARLOS, op. cit. loc. cit.

Frequently Asked Questions

Automatically Created

Can Portuguese residents claim a tax credit for US state income tax paid under Article 81 of the CIRS?
Yes, Portuguese tax residents can claim a tax credit for US state income tax paid under Article 81(1) of the CIRS. When state taxes are not covered by Article 2 of the Portugal-US Double Taxation Convention, they fall outside the Convention's scope. Article 81(1) CIRS serves as a residual provision protecting taxpayers from double taxation in situations not addressed by international treaties. Since the Contracting States deliberately excluded state taxes from the Convention, domestic Portuguese law applies, allowing taxpayers to credit foreign taxes paid against their Portuguese IRS liability to prevent economic double taxation.
Does the Portugal-US Double Taxation Convention cover state-level taxes for IRS tax credit purposes?
No, the Portugal-US Double Taxation Convention does not cover state-level taxes for IRS tax credit purposes. Article 2 of the Convention specifically lists the taxes to which it applies, and US state income taxes are not included. The dichotomy between federal and state taxes in the USA existed when the Convention was negotiated, and the Contracting States intentionally limited the Convention's scope to federal taxes covered by the Internal Revenue Code. This exclusion means state taxes must be addressed through domestic legislation rather than the treaty mechanism, making Article 81(1) CIRS the applicable provision for crediting such taxes.
What is the difference between Article 81(1) and Article 81(2) of the CIRS regarding foreign tax credits?
Article 81(1) CIRS applies when there is no double taxation convention between Portugal and the foreign country, or when specific foreign taxes fall outside the scope of an existing convention. It allows taxpayers to credit foreign income tax paid abroad against Portuguese IRS liability. Article 81(2) CIRS applies when a double taxation convention exists and expressly covers the foreign taxes in question, requiring application of the treaty's specific credit or exemption mechanisms. The key distinction is whether the foreign tax falls within or outside the convention's scope—Article 81(1) serves as the residual rule protecting against double taxation in situations not governed by treaty provisions.
How can taxpayers challenge an IRS tax assessment denying foreign tax credits through CAAD arbitration?
Taxpayers can challenge an IRS assessment denying foreign tax credits through CAAD (Centro de Arbitragem Administrativa) by first filing a gracious objection (reclamação graciosa) with the Tax Authority. If denied, they must file a request for constitution of an arbitral tribunal within the legal deadline (typically 90 days from notification of the decision). The request should be submitted under Article 2(1)(a) and Article 10(1)(a) of the RJAT (Regime Jurídico da Arbitragem Tributária), challenging the illegality of the assessment. Taxpayers should provide documentation proving foreign tax payment, demonstrate the legal basis for the credit under Article 81 CIRS, and argue why the Tax Authority's interpretation is incorrect. CAAD arbitration offers a faster alternative to judicial courts for resolving tax disputes.
Are Portuguese taxpayers entitled to compensatory interest when an IRS tax credit is wrongfully denied?
Yes, Portuguese taxpayers are entitled to compensatory interest (juros indemnizatórios) when an IRS tax credit is wrongfully denied. Under Article 43 of the General Tax Law (LGT), when the Tax Authority issues an illegal assessment resulting in excess tax payment, taxpayers have the right to indemnifying interest calculated from the payment date until refund. In CAAD arbitration proceedings challenging denied foreign tax credits, claimants routinely include a request for compensatory interest as part of their petition. If the arbitral tribunal declares the assessment partially or totally illegal and orders a refund, the Tax Authority must pay interest on the wrongfully collected amount, compensating taxpayers for the financial prejudice suffered during the period their funds were improperly retained.