On September 11, the Spanish Central Tax Court issued a landmark judgment that surprisingly has gone quite unnoticed (Spanish version here). Deviating from the historical position of the Spanish Supreme Court and the Ministry of Finance, this tax court concluded that individuals divesting in a company by selling their shares to it for their cancellation must be taxed under the capital gains provisions, as opposed to being treated as received dividends.

When a company buys its own shares at a higher price that their nominal value, it is transferring to the shareholder part of its reserves, so this could be construed as a profit distribution. This is particularly true when all the shareholders sell in proportion to their shareholding.

But legally, a sale of shares is always a transfer of assets, even if the acquirer is the company that has issued them. Therefore, understanding that income deriving from these transactions should be treated as capital gains also seems reasonable.

The Spanish Personal Income Tax Act has opted for a dual treatment. When the seller only transfers part of its shareholding and, therefore, remains as a shareholder, the dividend tax treatment applies. However, if the seller transfers all its shares and exits the company, our tax provisions treat any profits as capital gains.

The differences between the tax treatment of capital gains and dividends can be huge. It is true that Spain currently treats all types of investment income quite similarly, taxing them at flat rates under the so-called “savings basket.” Yet, capital gains arising from assets held before 1994 still benefit from certain rules that reduce or eliminate actual taxation.

The advantages of the capital gains treatment are even better when the selling shareholder is not a resident in Spain. Most of the tax treaties signed by Spain allow dividend withholding taxation but prevent Spain from taxing capital gains steaming from shares (certain exclusions to property-rich companies and substantial shareholdings can apply).

This different tax treatment has always been an incentive to carry out buyback transactions as a way of divesting from Spanish companies. But the tax inspection has scrutinized these arrangements very closely and challenged their capital gains treatment whenever there were any indications (no matter how weak) of an agreement between shareholders to distribute reserves. Many of these tax inspection assessments were finally confirmed by our courts.

The Central Tax Court judgment is simple and firmly grounded on the applicable provisions: if the shareholder exits the company, the capital gains treatment applies. It is only possible to apply the dividend treatment to this income if there are elements showing enough abusive planning to justify a substance-over-form approach.

In this BEPS context we live in, this judgment feels like a cool breeze for tax advisors. It reminds us of something tax inspectors wish would be forgotten: if the tax law treats two ways of achieving the same goal differently, opting for that which results in lower taxation is not an abuse but rather normal behavior anyone would expect from a reasonable person.