Partial Redemptions in Unit-Linked Life Insurance: A New Tax Debate in Portugal

Introduction

Unit-linked life insurance products have long occupied a privileged position within the Portuguese personal income tax (PIT) framework. Blending investment and protection features, they have historically benefited from favourable rules that lower effective taxation depending on the holding period. Until recently, litigation around these products was scarce. That has now changed.

A series of arbitration cases has opened a new front: the taxation of partial redemptions. The question is deceptively simple: when a policyholder withdraws part of their investment before maturity, should the redemption be treated as a repayment of capital, or does it include taxable income? The answer, however, has proven anything but simple.

Legal Background

Under the PIT Code, redemption proceeds from life insurance contracts are taxed as investment income (Category E), at a flat rate of 28%, with reductions to 22.4% or 11.2% available depending on the holding period.

The taxable amount is defined as the positive difference between amounts received and the premiums paid. This is straightforward in cases of maturity or full redemption. It is less clear, however, in the case of partial withdrawals, where the law provides no explicit mechanism for allocating capital and income.

Competing Interpretations

Two competing interpretations have emerged:

a) The Tax Authority’s “Pro-Rata” Approach

The Portuguese Tax Authority (AT) argues that partial redemptions inherently include an income component. According to this view, taxation should follow a pro-rata allocation: if the policy has appreciated overall, then any withdrawal is presumed to contain both a return of capital and a share of accumulated gains.

Example: if a policyholder invests €100,000, and the policy value rises to €120,000, a redemption of €30,000 would be treated as partly income. Even though total withdrawals (€30,000) remain below the original investment, the AT considers part of that amount to reflect realised gains.

b) The Taxpayer’s “FIFO” Approach

Taxpayers, by contrast, defend a first-in, first-out (FIFO) method: withdrawals are treated as a return of invested capital until the full amount of premiums has been recovered. Only subsequent redemptions are taxable as income. This interpretation reflects the principle of ability to pay, ensuring that tax is levied only on real – not hypothetical –  gains.

The FIFO view also mitigates the risk of taxing “phantom income.” Given market volatility, a policy may temporarily increase in value before declining again. Taxing notional gains at each partial redemption could leave taxpayers paying tax on income that never materialises by maturity.

The Case Law Divide

For several years, arbitral tribunals consistently sided with taxpayers, endorsing the FIFO interpretation. This line of decisions gave comfort to policyholders and advisors, aligning with conservative principles of PIT.

That consensus was recently broken. In a 2025 arbitration decision, the tribunal endorsed the AT’s pro-rata method for the first time, creating a direct conflict in case law. This reversal not only unsettles taxpayer expectations but also raises systemic concerns about consistency and fairness in tax enforcement.

Next Steps: Supreme Court Clarification

With the arbitration case law now split, the matter is headed to the Supreme Administrative Court for an acórdão de uniformização de jurisprudência — a binding ruling harmonising interpretation. The Court will need to resolve whether Portuguese PIT permits taxation of notional gains at each partial redemption, or whether income should only be recognised after the full recovery of invested capital.

Broader Implications

This is not a debate limited to a technical point about life insurance. It raises broader issues:

Timing of taxation – When should income be considered “realised” for tax purposes?
Principle of ability to pay – Is it consistent with constitutional principles to tax temporary gains that may never be definitively realised?
Market neutrality – Does the pro-rata method unfairly penalise long-term savings instruments, undermining their role in household financial planning?

Conclusion

The partial redemption debate highlights the tension between administrative pragmatism and fundamental tax principles. While the AT’s approach ensures early revenue, it risks taxing hypothetical income and undermining legal certainty. The FIFO approach, by contrast, better respects the taxpayer’s ability to pay but may defer taxation for many years.

The Supreme Administrative Court now faces a pivotal choice. Its ruling will shape the future of life insurance taxation.

Until then, taxpayers and advisors operate in a climate of legal uncertainty. For that reason, both should exercise caution when dealing with partial redemptions of unit-linked life insurance policies.

The outcome remains unwritten, and the final chapter of this debate is still to be told.