Capital Gains, Land Subdivisions and the IRS Transitional Regime: Revisiting Case Law

1. Preliminary remarks

Capital gains are increases in the value of elements comprising a given estate. For tax purposes, they generally correspond to the difference between the amount received from the disposal of an asset (realisation value) and the value that asset held when it entered the transferor's estate (acquisition value). Under IRS they are alternatively taxed either as passive income, arising in an unprovoked, unexpected and unusual manner (windfall profits)1, or as active income, obtained as a result of a recurring economic activity pursued by their holder with a view to appreciating those assets2.

In either case, it is upon the occurrence of realisation events that capital gains are computed, with a view to determining the tax due. Since the income derived therefrom depends essentially on two taxable facts occurring at chronologically successive moments, for as long as that realisation event does not occur, taxpayers will have, at most, latent capital gains. Latent capital gains are nothing more than the expectations that taxpayers may legitimately form as to the amount they can obtain at any given time from the sale of their assets. And so, the topic of capital gains is also intimately associated with the forecasting that taxpayers must be able to make as to the taxes resulting from that realisation.

Accordingly, any legislative amendment relating to the calculation of capital gains generates an inherent retroactivity, since it alters the value of assets comprising the private estate, changing the rules mid-game. And with them, the expectations that began to be formed many years earlier, at least from the date of acquisition of those assets3.

This paper revisits the case law on the transitional regime for category G, adopted with a view to minimising the impact that the approval of the IRS code has on assets held by taxpayers at the date of its entry into force. The analysis draws on a sample of forty rulings issued by the Supreme Administrative Court and the Central Administrative Courts between 2006 and 2024, focusing on the issues raised by that transitional regime, which rests essentially on a distinction between active and passive capital gains, with obvious consequences for the classification of the income arising therefrom.

The analysis starts with a brief description of the category G transitional regime, moves on to an examination of the mapped case law, analysing its general direction and the borderline situations resolved, including an analysis of decisions that diverge from the trend generally adopted by those courts. It concludes by pointing to the main implications of classifying income as category B gains, raising the new problem generated in this context by the amendment introduced by the 2021 State Budget — the absorption of taxation under the category B rules — an amendment that apparently eliminates tout court any access to the transitional regime where immovable property is allocated to the holder's business and professional activity. The paper ends with a summary of the main conclusions.

2. The transitional regime of category G

With the entry into force of the IRS code4, personal income tax introduced an analytical approach to income taxation5, beginning to treat capital gains in a far broader and more systematic manner than before. It was therefore accompanied by a transitional regime that would allow the effect of the new rules to affect the value of assets held at the date of its entry into force as little as possible6.

Under this regime, gains that (i) were not subject to capital gains tax7, as well as those (ii) derived from the onerous disposal of rural land allocated to the pursuit of an agricultural activity or (iii) from their allocation to a commercial or industrial activity carried on by the respective owner, are only subject to IRS if the acquisition of the assets or rights to which they relate was made after the entry into force of the IRS code8.

To understand the evolution of case law on the application of the category G transitional regime, what follows is an analysis of case law that seeks to determine the meaning and evolution of decisions relating to immovable property acquired before the entry into force of the IRS code which, after that date, acquired the nature of building plots. And among these, the meaning of decisions in which that nature arose from the approval of subdivision operations promoted by their owners or by third parties.

3. Case law analysis I: general direction

The category G transitional regime has always generated questions that, over the past decades, have merited the attention of our superior courts. Here, the settled and repeated case law soon consolidated around the position that IRS does not apply to gains obtained from the onerous transfer of land acquired as rural property before the entry into force of the IRS Code, which still retained that nature when the Code entered into force (1 January 1989), even if it subsequently acquires the nature of a building plot and is disposed of as such9.

It so happens that, despite the questions of application of the transitional regime being raised in situations where it is presupposed from the outset that one is dealing with category G income10, it has always involved a certain measure of discussion about the possible classification of income obtained from the sale of the properties in question as category B income. To that extent, never far from the discussion was the issue of whether the gains in fact fell to be taxed under the rules applicable to such income, beginning with the rule of the immediate applicability in such cases of the category B regime to such legal situations, including those initiated before its entry into force11.

Thus, and notwithstanding some fluctuations that will be noted, our superior courts have commonly held that the multiple operations necessary to transform a rural plot into building plots for urban construction, carried out over several years for subsequent sale — even when carried out jointly with other interested parties — lead to appreciations that can never be considered occasional, or the result of chance or luck12.

In this way, the courts have held13 that the profit resulting from that set of acts cannot be considered a passive appreciation, the result of external circumstances, but rather as the result of commercial or industrial activities performed by the holders, even if they do not habitually pursue that activity14. For this reason, it has been held that these situations should be classified, not as capital increments, but rather as income from independent work, even if resulting from a single isolated act15, being taxed in accordance with the assessment rules applicable to category B income16.

And as mentioned above, the classification of the gains in question as category B income precludes the application of the transitional regime set out in Article 5(1) of Decree-Law no. 422-A/88 of 30 November, which was clearly designed and intended for passive capital gains of an immovable nature, classified as capital increments and taxed in accordance with the rules applicable to that type of income (category G)17.

4. Case law analysis II: borderline situations

Associated with these cases are essentially two borderline situations, as they deal with issues subsequent to the case law described. They relate first to the approval of or application for subdivision lodged before the sale but essentially unrelated to the seller, being promoted exclusively by the prospective purchaser of the properties. They also relate to situations where the owner, prior to the sale, sought an opinion on the construction feasibility of the property they intended to sell.

In the first set of situations, where the property owners merely authorised third parties interested in purchasing the property to promote subdivision operations with the competent authorities, carrying out the acts necessary for their completion, the courts have consistently held that the gains resulting therefrom are unexpected or fortuitous, and thus classified as category G income18. And where owners, likewise before the sale, file prior information requests, asking municipalities for opinions on the urban construction potential of their properties, the case law has uniformly held that this fact does not prevent the gains obtained from the sale from being classified as category G income.

Accordingly, in both cases, where no other relevant circumstances arise and the conditions set out in Article 5(1) of Decree-Law no. 422-A/88 of 30 November are met19, the same shall apply, with the gains obtained falling outside the scope of the provision.

5. Case law analysis III: divergent decisions

However, the analysis of the sample also revealed that over the years decisions were issued that are difficult to reconcile with the case law described above. These are decisions whose established facts include circumstances which, in light of the decisions analysed above, would reasonably be expected to produce a different outcome. In chronological order, these decisions are:

• ruling of the STA of 20-05-2015 (case 0149/15): in this ruling the court did not give weight to the fact that, in 1994, the property owner, together with others, had been the applicant in a subdivision process for the plot that was subsequently sold still as rural land in 2004;
• ruling of the TCAN of 07-12-2017 (case 01456/08.9BEPRT): in this ruling the court did not give weight to the fact, established in the findings of fact, that the owner demolished a two-storey building on the plot acquired in 1985, subsequently requesting and obtaining the segregation of an area (approved in 2003), resulting in two urban building plots which the applicant sold in 2005;
• ruling of the TCAS of 14-01-2020 (case 217/10.0BELRS): here the court downplayed the fact that the owner had applied for a permit to build a gated condominium on property acquired before 1989, an application which was granted in 2003, before that property was disposed of in 2004;
• ruling of the TCAS of 05-03-2020 (case 936/12.6BESNT): in this ruling the court did not give weight to the fact that the owner had promoted a subdivision operation that gave rise to the urban building plots subsequently disposed of, the transitional regime being applied to the part of the property acquired before 1989;
• ruling of the TCAS of 28-01-2021 (case 195/09.8BELRS): in this ruling, the court did not give weight to the fact that the owner had applied for subdivision in 1994, ultimately selling the property in 2004 to a company which immediately thereafter registered as applicant in the same subdivision process;
• ruling of the TCAS of 15-04-2021 (case 1059/12.3BELRS): here, the court downplayed the multiple steps taken to enhance the value of the property — entry into contracts for services (i) for real estate project development, (ii) for the construction of a high-quality tourist complex, (iii) approval by the Directorate-General for Tourism of a location plan for a tourist complex, (iv) preparation of subdivision projects — which was ultimately sold to a company for a high value.

6. Main implications of taxation under the category B rules

The exclusion of the transitional regime by virtue of the application to these cases of the category B rules was recently revisited in an impressive ruling of the STA20, which decided a specific case in which the owner of a rural plot acquired in 1964 had taken steps: (i) for the preparation of a subdivision and infrastructure project, (ii) for the submission of those projects for approval in 1998, (iii) promising to sell the said property to a real estate company in 1999. The established facts further show that (iv) from the time that promise-of-sale contract was entered into, the purchasing company took over handling all matters relating to the subdivision process (without prejudice to the applicant occasionally signing requests to be submitted to the competent municipality), (v) the subdivision permit having been issued in September 2004, (vi) and the public deed of purchase and sale having been executed the following month.

On the classification of the gain obtained by the owner from the sale of that property, the STA stated it to be settled case law at this point that income derived from the disposal of building plots, preceded by acts conducive to subdivision carried out by the seller himself, must be classified as category B income, even where resulting from an isolated act21. It reasons that this classification follows from the active nature of the income, resulting from the commercial or business activity developed by the transferor in enhancing and promoting that gain. An intervention that definitively precludes the possibility of classifying the gain obtained from the disposal of the building plot as passive income or a "windfall gain", which would fall under category G, deciding instead that, since those gains are classified as category B income, the transitional regime designed and intended for category G naturally does not apply to them22.

As a consequence of classifying those gains as category B income, the accounting-based assessment rules set out in the IRC code must also be considered23, in particular those on the determination of taxable profit. This means that in its calculation all expenses and losses incurred or borne by the taxpayer to obtain or secure income subject to IRS may be deducted, pursuant to Article 23 of the IRC code. And where the activity is carried on jointly with other professionals, expenses shall be apportioned in proportion to the use made by each, or in the absence of elements allowing apportionment, proportionally to the gross income earned.

Furthermore, in determining the tax capital gain relating to the transfer of assets allocated to the activity, the rules contained in Articles 46 and 48 of the IRC code apply, with the tax capital gain calculated accordingly24. In the case of individuals, and unlike the treatment of category G capital gains, which are taxable on only 50% of their value, this means that capital gains classified as category B income are generally computed, aggregated and taxed in full, notwithstanding the broader scope for deducting expenses.

7. The new absorption effect of taxation under the category B rules

On the other hand, as a result of the allocation to the business activity of the owner of an asset previously allocated to their private estate, at the time of the subsequent onerous disposal of the building plots in question, two gains would need to be computed: (i) one resulting from the allocation, at market value at that date, of the property to the owner's business and professional activity (taxed as category G income); (ii) and another, arising from the disposal of the plots resulting from the subdivision activity carried on (taxed as category B income). To that end, and as evidenced by the ruling under review, it was necessary to determine "ultimately, the year in which the subdivision licensing was promoted — and subsequently, to fix a market value for it (at the very least, by approximation with the value of transactions recorded at that date)."25

This solution made sense because, by separately taxing the latent gain resulting from the appreciation of the property relating to the period prior to its allocation to the activity of active promotion thereof, it was possible to safeguard the analytical nature of IRS, taxing as passive income (category G) the capital gain resulting from factors external to the owner's activity, and as business income (category B) the part of the capital gain attributable to their active intervention and sustained effort.

It so happens that, with Law no. 75-B/2020 of 31 December26, this differentiated treatment was eliminated. The gains resulting from the allocation of immovable property belonging to the private estate to commercial, business and professional activity carried on in individual capacity by the owner ceased to be separately assessed as category G capital gains. In such cases, in the event of the subsequent onerous disposal of the assets in question, the entire capital gain is now taxed under the category B rules, making it possible to speak of an absorption effect of the totality of the passive gain by the rules applicable to professional or business income.

A solution that, besides mitigating the analytical nature of IRS by treating equally income of different typologies, generates in these cases a triple injustice and gives rise to the question of the constitutionality of Article 364 of Law no. 75-B/2020 of 31 December, insofar as it amended Article 10(1)(i) of the IRS code. And the merits of that constitutional question arise, first and foremost, because:

• first, because in the cases in question, where almost the entire holding period of the properties occurred while they were in the private sphere of their owners, a very significant part of their appreciation is of passive origin and accordingly merits the specific treatment provided by law for that type of income (capital increments)27;
• next, because this amendment, in practical terms, excludes from access to the transitional regime owners who allocate to a business activity properties acquired before 1989, subjecting them to the retroactive effect that the decree-law approving the IRS code expressly sought to avoid. This exclusion is all the more serious because a very substantial part of the appreciation of current immovable property acquired before 1989 that meets the conditions set out in the transitional regime is of passive origin and results from circumstances external to the owners' intervention;
• finally, because by implying that owners who allocate to a business activity properties that abstractly meet the conditions set out in the transitional regime do not benefit from it, it creates a wholly arbitrary discrimination between them and those who, not having made such an allocation, also intend to dispose of those properties. A discrimination of heightened gravity because in such cases certainly more than 90% of the holding period of those properties will have elapsed while integrated in the private estate. And it ensures that those who allocate such properties to business activity are subjected to the same retroactivity that the legislator who created the IRS code sought to avoid, and that the 1997 constitutional revision expressly prohibited.

Be that as it may, and notwithstanding the scenario described above, it is possible that that amendment may ultimately not produce the effect described, since under the transitional provision which is again transcribed28, "Gains that were not subject to capital gains tax, created by the code approved by Decree-Law no. 46 373 of 9 June 1965, as well as those derived from the onerous disposal of rural land allocated to the pursuit of an agricultural activity or from their allocation to a commercial or industrial activity carried on by the respective owner, are only subject to IRS if the acquisition of the assets or rights to which they relate was made after the entry into force of this Code."

8. Conclusions

A. Under IRS, capital gains may be taxed either as passive income (windfall gains) or as active income (resulting from a recurring economic activity).

B. Because capital gains are computed upon the occurrence of realisation events, any amendment to tax law may interfere with the value of assets held at the date of its entry into force, generating an inherent retroactivity resulting from the projection of its effects onto acquisitive taxable facts occurring before its entry into force. A projection that deprives the owners of those assets of the possibility of making an ex ante forecast based on the new rules.

C. With the entry into force of the IRS Code, personal income tax began to treat capital gains in a more comprehensive and systematic manner, and was therefore accompanied by a transitional regime intended to minimise its impact on the value of assets existing at the date of its entry into force.

D. Case law has consolidated the position that gains obtained from the onerous transfer of land acquired as rural property before the entry into force of the IRS Code, which still retained that nature when the Code entered into force (1 January 1989), are not subject to IRS, even if the land subsequently acquires the nature of a building plot and is disposed of as such.

E. With limited exceptions, the superior courts have equally accepted the view that gains resulting from the sale of plots, following subdivision operations carried out by the seller, should be considered category B income.

F. The fact that the owner seeks opinions on construction feasibility before the sale, or that subdivision of the property is promoted exclusively by the buyer, does not interfere with the characterisation of the gains as unexpected or fortuitous, classifying them as category G income with the consequent application of its transitional regime.

F. Where gains from the sale of properties are classified as category B income, taxable income is computed on an accounting basis, with the deduction of all expenses and losses incurred to obtain or secure income, and the tax capital gain relating to the transfer of those assets is calculated under the IRC code. In particular, this means that unlike the rules for category G capital gains, which only consider 50% of their value as a capital increment, capital gains classified as category B income tend to be taken into account at their full value.

G. The amendment introduced by Law no. 75-B/2020 of 31 December has significantly affected legal certainty as to the taxation of this income, since in cases of allocation of immovable property from the private estate to commercial, business and professional activity carried on in individual capacity, the capital increment prior to that allocation — potentially not subject to tax under the category G transitional regime — is no longer separately computed.

H. Consequently, in a cautious reading of the current regime, and without prejudice to the constitutional considerations set out in the text, it must be borne in mind that the allocation, made after 1 January 2021, of any rural or urban properties acquired before 1989 — which between their acquisition and the entry into force of the IRS code did not acquire the nature of building plots — to commercial, business and professional activity carried on by their owner, apparently results in the total inapplicability for such taxpayers of the transitional regime provided for in the law for category G income.