Scenarios of foreign investment in Spain

We should start with a foreword on the legal differences between the branch and the subsidiary, since both concepts often get mixed in layman’s language.

The branch doesn’t have a separate legal personality and operates as an instrument of the head office. Thus, it is the head office itself which, by the means of an appendix abroad (Spain, in our case), called “branch” or “permanent establishment” (PE), takes its economic activity beyond its borders. The most remarkable consequence of opting for this modality is that the head office will have unlimited liability for all the debts incurred by the branch, without any kind of patrimonial separation between both of them, considering that the branch is but a mere functional subdivision of the head office for commercial purposes.

However, the subsidiary has an independent legal personality, although the parent company exercises control over it, and normally it holds the power of decision. According to the Parent-Subsidiary European directive, the parent company must have at least a 10% of the shares of the subsidiary. The typical case would be an ownership of 25% of the shares or higher.

Such disparity in types between the branch and the subsidiary has, as we shall see, many consequences in the commercial and tax management fields.

As for the requirements of constitution, the branch neither requires to be equipped with its own bylaws nor demands a minimum capital (3.000.-€ or  60.000.-€ in the case of the subsidiary, depending on whether it is a limited liability company, “S.L.”, or a stock company, “S.A.”). It is recommended, however, that some funds are available so that the branch is not considered undercapitalized based on the financing required for its economic activity, which must be calibrated depending on its nature and magnitude.

On the other hand, having a branch or PE will force us to designate one or more permanent representatives, communicating them to the Spanish Tax Office. This is due to the fact that the branch is labelled by the Spanish Administration as a nonresident entity, given that its head office wasn’t incorporated under Spanish laws and has no registered office or place of effective management in Spanish territory. The permanent representative shall be jointly and severally liable in any case for all the tax debts of the branch, without negligence or culpability on his part and without the declaration of the failure of the branch being needed. There will be also criminal liability in cases of tax fraud. If there is no permanent representative or it hasn’t been communicated, the Tax Office will be entitled to deem as a representative whoever that  is empowered to contract in Spanish territory on behalf of the head office.

The most immediate fiscal consequence of the nonresident nature of the branch is that it will be taxed by the Income Tax of Non-Residents (IRNR, in Spanish) instead of being taxed by the Corporate Tax (IS). The fiscal regime will be substantially different, although the Tax Office treats the branch as an ordinary company with its own trading account and equity. The differences can be summarized in the following points:

• First consequence: It will be easier to justify the deductibility of expenses of the head office regarding the branch, as far as they are reasonable and are included in the annual informative report.

In contrast, a subsidiary, which assumes greater organizational autonomy, will surely need further evidence in order to prove the reality of such expenses.

However, not all expenses incurred by the branch and payable to the head office are recognized by Spanish law as tax deductible. Thus, we will have to proceed to increase the taxable basis in the amount of interests, royalties and other fees from the head office that have been accounted as expenses in the branch. That is, these costs will not be deductible for the branch. The philosophy of this permanent fiscal adjustment is that there has been a real expense, but a mere internal flow of goods, services and money.

Such philosophy applies logically in reverse in the case of the subsidiary, so that its expenses regarding interests, royalties and other fees from the parent will be tax deductible in Spain.

We must also consider that not all the transactions between related companies will be taxable. In the context of the European Union (Directive 2003/49/EC) the payment of interests between associated companies will be tax exempted. As for the concept of “associated companies”, it refers to the corporate entities that participate in other companies in at least 25% of the shares, or are participated at the same percentage. Branch offices are included in this tax exemption.

• Second consequence: The standard tax rate for a branch in Spain used to be 35%, ten per cent higher than the one established in Corporate Tax (25%). This changed in 2015 and in this year both rates are 28% on the revenue (25% from 2016 on). Nonetheless, there are still differences, since some allowances only apply with Corporate Tax, like the freedom of amortization for medium sized and small companies (less than 10 million euros of turnover), among others.

As in the Corporate Tax, the tax rate of the IRNR can be reduced five points (20%) if there is a maintenance of the workforce or a creation of new jobs during the fiscal year; or even can be decreased in ten points (15%) in the first two years of positive results if the company was created in 2013 or later.

Once again, the medium sized and small companies which are considered resident will have special benefits in 2015, being taxed generally at a 25% for the first 300.000.-€ of revenue, and at a 28% for the rest. From 2016 on, they will be taxed at a 25% without distinction.

• Third consequence: For non-resident companies there is an additional charge of 19% for transfers abroad (20% in 2015), whose intention is to assimilate at this point the status of the branch to the one of the subsidiary when it pays dividends to its parent company, where a withholding of 19% also applies (20% in 2015). Since the branch has no legal personality, it is not owned by any other company and cannot distribute dividends of any kind. Therefore, the mere capital outflow beyond our borders is taxed, assuming that the aim pursued is to repatriate the profits. Depending on the country concerned, this supplementary levy could enjoy a partial or total deduction in order to avoid international double taxation, and won’t exist in any case between companies resident in countries belonging to the European Union (except tax havens).

In general, profits distributed by the subsidiary to its parent company are tax exempt if both companies reside within the European Union. This exemption does not apply if the distribution is made in connection with the winding up of the subsidiary.

Regarding the subsidiary of a parent company that is a resident outside the EU, it will predictably suffer international double taxation of dividends. Thus, it is a standard clause in bilateral agreements between Spain and other contracting countries to establish limits to the Spanish Corporate Tax, not exceeding 15% of the gross amount of dividends, or 5% if the participation in the subsidiary is of a 25% or more. In turn, the equivalent tax in the country of residence of the parent may be neutralized in the part paid in Spain.

Finally, non-resident companies that are resident in tax havens will need to pay yearly a 3% of the cadastral value of the real estate they own in Spain.

• Fourth consequence: In an unlikely scenario, it is possible that the Spanish Administration determines the profit that the branch would have obtained if it existed independently from its head office. It could only happen when  there is no rational criteria in the expenses reflected by the PE in its accountancy.

Between the subsidiary and the parent company any related-party operations could demand defense files justifying the reality and amount of the managing fees. This would help our company to minimize the risk of a Tax Inspection with a revaluation of the taxable basis.

As a final comment, we must note that operating without a branch or subsidiary in a foreign country (ie, operating directly in Spain without a permanent establishment or a resident company) is also possible, but entails even greater restrictions on the tax regime.

In these cases the tax rate is 24% (19% for entities resident in countries within the EU). Still, the law only allows a tax deduction of staff costs, material procurement costs and supplies, rejecting any other item that can not be brought under these concepts. Nonetheless, the companies resident within the UE that operate in Spain without a PE will be able to deduct any other kind of expenses if it can be proved that they are directly linked to the economic activity in Spain.

Taxation here must proceed operation by operation, since there is no taxable year that can apply, existing only the possibility to declare all operations cumulatively every quarter. Since we will declare independent accruals based on different projects, a significant part of the costs won’t be deductible (eg, mediation services and other business fees offered by the parent). Moreover, all ordinary Corporate Tax deductions won’t apply, except for the deduction for donations to non-profit entities, which is usually irrelevant. Finally, there won’t be any legal choice to compensate the projects that yield benefits with the deficient ones.

In a nutshell, there are three possible scenarios of investment in Spain for foreign entrepreneurs, each with different consequences as regards the applicable taxation of each legal vehicle, depending on it being a branch, a subsidiary or an economic activity without permanent establishment. The nature of each activity (amount and type of planned expenditures, estimated duration of the business, desired level of risk and responsibility, brand identity, etc.) will determine the best strategy to follow.

We are available to answer your questions and implement any project on this regard. Please don’t hesitate to contact us.

CONSULTANCY AREA