The 1% income tax treatment, instead of the standard 19% tax, is available to non-Spanish tax resident alternative investment funds (AIFs). Or so the Spanish Supreme Court says, if you meet certain comparability criteria.

Note: The Spanish tax statute of limitations is four years!

Starting from the beginning, Spanish AIFs a.k.a. hedge funds (which are not harmonised under the UCITS Directive 2009/65/EC) are deemed to be Spanish resident taxpayers subject to the general Spanish corporate income tax, albeit with a reduced 1% tax rate on their profits (typically comprised  of dividends, interest, and capital gains).

This privileged tax treatment compares poorly to that applicable to non-Spanish tax resident AIFs (non-Spanish AIF) in comparable circumstances. Indeed, the latter are generally subject to Non-Resident Income Tax at a 19% rate on Spanish-source income (in certain cases, gross), unless a lower rate is applicable by virtue of a tax treaty in force between Spain and the jurisdiction in which the AIF is tax resident.

In this context, based on the CJEU’s case law, the Spanish Supreme Court issued five rulings on 5, 11 and 25 April 2023 declaring that Spanish tax law leads to an unjustifiable difference in the treatment of non-Spanish and Spanish AIFs that is discriminatory and contrary to the EU principle of free movement of capital enshrined in Article 63 of the Treaty on the Functioning of the European Union. This infringement derives from the absence in Spanish tax law of a provision setting out the comparability conditions so that non-Spanish AIFs can benefit from the same tax treatment as Spanish AIFs, and a procedure under which non-resident AIFs comparable to Spanish AIFs can request a refund of the amounts withheld that exceed what a Spanish AIF would have had been taxed on in relation to Spanish-source dividends.

In view of the Spanish legislation’s infringement of EU law, a comparability analysis between non-Spanish and Spanish AIFs must be carried out to determine the conditions under which the former should be able to claim a refund of the amounts of tax withheld at source at a rate exceeding the final tax which would be due from Spanish AIFs. In the absence of applicable domestic legislation, following the Supreme Court, this comparability analysis must be performed on the basis of the essential intrinsic elements that must exist for a Spanish AIF to benefit from the tax treatment set out in the Spanish tax legislation, and the rules applicable to this type of AIF in its state of residence.

In particular, the Spanish Supreme Court has identified the following requirements as essential to conclude that a non-Spanish AIF is comparable to a Spanish AIF:

• the non-Spanish AIF must raise capital contributions from the “general” public (therefore excluding those that limit access to family or other specific groups). Nevertheless, access may be limited to professional investors or investors with a certain level of training in and knowledge of the securities markets;
• the non-Spanish AIF must be authorised to operate by the relevant supervisory authority with authority over collective investment vehicles in its jurisdiction of formation (equivalent to the Spanish National Securities Market Commission); and
• non-Spanish AIFs resident in the EU must be managed by an entity authorised in its state of residence as an AIF Manager under the terms of Directive 2011/61/EU.

The burden of proving that the above requirements are met falls on the non-Spanish AIF, but the fact that the Spanish legislation does not specify the type of evidence required cannot be understood as allowing the Spanish tax authorities to demand that the non-Spanish AIF provides evidence or certificates that are strictly identical to those required for Spanish AIFs, nor other types of documentation that are disproportionate or extraordinarily difficult for the non-Spanish AIF to obtain.

As an exception, the Supreme Court concluded that no discrimination would exist in cases where an applicable tax treaty allows the non-Spanish AIF to credit —in the jurisdiction where it is resident— the taxes paid in Spain, up to the limit of those that would have applied to a Spanish AIF (i.e. 1% of the dividends). However, as most AIFs are either tax exempt or not subject to tax, it is unlikely that such a situation will arise.

Finally, while, in principle, these rulings relate to EU AIFs, the same rationale should apply to AIFs that are resident outside the European Union.

As a final note, Spanish source dividends and interest will still carry a 19% dividend withholding tax (or the reduced withholding tax rate applicable under a tax treaty), so the non-Spanish AIF will be forced to request a refund from the Spanish tax authorities of the excess 18% of tax withheld, a process which will be lengthy and can be costly.