On December 18, 2012, the Spanish Tax Authorities issued a tax ruling that introduced a new criterion in connection with the applicability of the Spanish participation exemption. The new ruling has consequences for sales of participation in qualifying foreign subsidiaries.

Under the Spanish Corporate Income Tax (“CIT”) Act, a capital gain derived from the transfer of a foreign subsidiary could be exempt from CIT provided certain requirements are met. In a nutshell, such foreign subsidiary must meet three different tests: a) the shareholding held by the Spanish parent in such foreign subsidiary (directly or indirectly), must be of at least 5 percent (and must have been held for a minimum one year holding period prior to the sale event) (the “minimum holding requirement”); b) the foreign subsidiary must have been subject to a foreign tax deemed to be similar to the Spanish CIT (entities resident in jurisdictions having a tax treaty providing for an exchange of tax information clause are deemed to meet such requirement) (the “subject-to-tax”requirement); and c) at least 85 percent of the foreign subsidiary’s revenues, in each fiscal year ended during the shareholding’s holding period, must not have derived from “passive income”, but rather, must have derived from the performance of business activities (the “business revenues” requirement). In that regard, dividends and gains derived from lower-tier subsidiaries are deemed to qualify for the “business revenues” requirement to the extent such lower-tier subsidiaries could be deemed to be qualifying foreign subsidiaries themselves.

Until fiscal year 2012, in order to benefit from a capital gains tax exemption, the foreign subsidiary whose shares are sold should meet both the “subjectto-tax” requirement and the “business revenues” requirement in each and every fiscal year ended since the acquisition of such stake. In case any of these requirements was not met in a single fiscal year ended during the subsidiary’s holding period, the applicability of the participation exemption was denied in full. Needless to say, the applicability of such an “all-or-nothing” rule could be challenging, especially in the context of multinational groups. In particular, when a Spanish parent company held investments in foreign operating subsidiaries through a foreign “subholding” vehicle, ensuring the fulfillment of such requirements during the entire holding period required extensive monitoring, especially since the Spanish Tax Authorities considered that the fulfillment of the participation exemption requirements should be tested on an “entity-by-entity” basis.

In other words, if a Spanish parent company had investments through a foreign subholding vehicle and sold the shares of such subholding, if the subholding —on a standalone basis — failed to meet the participation exemption requirements in a given year (due to e.g., the non-compliance with the “business revenues” test), the participation exemption could not be claimed with respect to the capital gain realized. This would be true even though the lower-tiered foreign operating subsidiaries met the requirements set forth under the participation exemption rules. With its new ruling, the Spanish Tax Authorities have tried to offer a more flexible interpretation of the abovementioned rule in certain cases. For instance, in certain cases, the Tax Authorities found that “passive” interest revenues accruing at the level of a foreign subholding (related to interest-bearing bank deposits) did not jeopardize the applicability of the participation exemption even when theyexceeded 15 percent of the total revenue of such subholding in a given fiscal year, where the cash invested derived from dividends or gains derived from lowertiered subsidiaries qualifying for the participation exemption, or where the foreign subholding had net operating losses in the fiscal year in which the “business revenues” test was not met.

In 2012, there was a significant development on that front, when the Spanish legislature amended the participation exemption rules to change the “all-ornothing” approach adopted in order to determine whether a capital gains tax exemption could be available. Under the new rule (in force since fiscal year 2012), in case the “subject-to-tax” or the “business revenues” test were not met in a given fiscal year during the foreign subsidiary’s holding period, only the portion of the capital gain that could be deemed to be attributable to such year would be taxable. The portion of the gain attributable to other fiscal years in which such requirements were met could be tax-exempt. In that respect, the amount of the gain that could be deemed attributable to the foreign subsidiary’s goodwill (and not to accumulated reserves at the level of such subsidiary) would be deemed to have accrued on a straight-line basis during the holding period (unless the taxpayer could prove otherwise).

While the enactment of such changes to the participation exemption rule has improved greatly the applicability of the participation exemption rules, the Spanish Tax Authorities took an additional step forward in December 2012, when they issued Binding Ruling V2477-12. With its December ruling, the Spanish Tax Authorities depart from their position that the participation exemption rules required testing of the fulfillment of its requirements on an “entity-by-entity” basis. In other words, the Spanish Tax Authorities admit that the fulfillment of the applicable requirements, in structures in which a foreign subholding entity holds the shares of lower-tiered subsidiaries, may be tested on a consolidated basis. See below for a brief description of the background and features of the ruling.

In the case described in Binding Ruling V2477-12, dated December 18, 2012, a Spanish parent company that was fully owned by a Canadian company, and which had the status of an ETVE (i.e., the special Spanish holding company regime), held participations of various operating foreign companies through subholding entities. One of such subholding entities (resident for tax purposes in Luxembourg) did not meet the “business revenues” test on a standalone basis, as more than 15 percent of this entity’s revenues in some fiscal years ended during its holding period derived from “passive” financial income that did not qualify for the “business revenues” test. Such subholding held the shares of more than 20 operating entities resident in Latin American countries, all qualifying for the participation exemption regime.1 In case any of these lower-tiered subsidiaries had paid up a dividend to the Luxembourg subholding (or if the subholding sold its investment in any of these entities) the dividend or gain realized would have been deemed to be a qualifying revenue for purposes of the “business revenues” test. In the event the “business revenues” test applied with respect to the combined revenues of the Luxembourg subholding and its operating subsidiaries, though, the “business revenues” test would have been met.

In the case described in the Binding Ruling, the Spanish parent company intended to transfer its tax residence from Spain to Luxembourg, which would give rise to an “exit tax.” The income required to be reported by the Spanish parent company for exit tax assessment purposes would be equivalent to the unrealized capital gain embedded in its assets (including the shares of the Luxembourg subholding). In that context, the Spanish parent company inquired with the Spanish Tax Authorities regarding the possibility of testing the “business revenues” test on a consolidated basis (i.e., combining the revenues of the Luxembourg entity and of its lower-tier subsidiaries) instead of on an “entity-by-entity” basis. The acceptance of such criterion would mean that the “business revenues” test would be met in all fiscal years ended during the holding period of the Luxembourg entity’s shares. If so, the entire “deemed capital gain” would be tax-exempt under the participation exemption rules.

In their reply, the Spanish Tax Authorities concluded that since the Luxembourg subholding was a holding entity, it would be possible to test the “business revenues” test by combining the revenues of the entity and all of its subsidiaries (direct or indirect). The consolidation of such revenues at the level of the subholding entity would require performing the following adjustments: i) only the portion of the subsidiaries’ revenues corresponding to the ownership percentage of the subholding in such subsidiaries would be attributable to the subholding; ii) dividends paid by entities included within such consolidation perimeter (and received by companies also included therein) would not be taken into account, as their inclusion would have a “double-counting” effect. Once such adjustments are performed, in case more than 85 percent of the combined revenues obtained by the Luxembourg subholding and its subsidiaries in a given fiscal year qualified for the “business revenues” test, such test would be deemed to be met in such fiscal year.

Conversely, in case the combined revenues qualifying for the “business revenues” test were below the 85 percent threshold in a given fiscal year, then the portion of the capital gain realized upon the deemed transfer of the Luxembourg subholdingthat was attributable to such fiscal year would be taxable (by applying the criteria set forth under the rules enacted in 2012, described above).

Subject to the Binding Ruling, it is possible to anticipate that many multinational groups having a Spanish holding company (and which hold investments in lowertiered subsidiaries through foreign subholding vehicles) may benefit from new criteria and may improve the Spanish tax treatment of the capital gains realized upon a potential divestment in such subholding vehicles. In addition, the task of monitoring the fulfillment of the participation exemption requirements through the life of such investments will be greatly simplified. However, it should be noted that there are certain questions that remain unanswered by the Biding Ruling, such as how this criterion would apply where the subholding vehicle also owns investments in lower-tiered entities that would not qualify for the “subject-to-tax” test. Given the new avenues opened by this Binding Ruling, it is possible to expect that other taxpayers will submit other cases to the Spanish Tax Authorities testing the limits ofthe new criteria.