Reverse Merger Financing Costs Deductible Under Article 23 CIRC – CAAD 120/2017-T

ENGLISH TRANSLATION

The arbitrators José Baeta de Queiroz (arbitrator-president), Tomás Cantista Tavares and Jorge Carita (arbitrator-members), designated respectively by the CAAD (in the absence of agreement among the arbitrators appointed by the parties), by the Claimant and by the Respondent to form the Arbitral Tribunal, hereby agree on the following:

1. Report

A…, SA, NIPC…, with registered office at Travessa…, …, …, Vila Nova de Gaia (hereinafter A… or Claimant), filed a request for constitution of the collective arbitral tribunal, pursuant to the combined provisions of Articles 2º, no. 1, para. a), and 6º, no. 2, para. b) of Decree-Law no. 10/2011, of 20 January (Legal Framework of Arbitration in Tax Matters, hereinafter RJAT), in which the Tax and Customs Authority (hereinafter AT) is the Respondent, with a view to declaring the illegality of the assessment of Corporate Income Tax (IRC) and interest for the year 2012 (2016 … and compensation 2016 …), in the total amount of €982,980.06.

The request for constitution of the arbitral tribunal was accepted by the Chairman of the CAAD and followed its normal procedure, namely with notification to the AT. All arbitrators communicated their acceptance within the applicable time period. The parties did not manifest their intention to refuse the appointment of the arbitrators.

The collective arbitral tribunal was constituted on 4/5/2017.

The AT responded, arguing that the request should be ruled unfounded.

By order, with the agreement of the parties, the meeting provided for in Article 18º of the RJAT was not held; the parties were invited to make written submissions; the claimant did not do so and the respondent submitted arguments, maintaining what it had stated in its response.

The arbitral tribunal was duly constituted and is materially competent, as provided for in Articles 2º, no. 1, para. a) and 4º, both of the RJAT.

The parties have standing and legal capacity, are legitimate and are represented (Articles 4º and 10º, no. 2, of the same enactment and Articles 1º to 3º of Ordinance no. 112-A/2011, of 22 March).

The proceedings are free from defects and there is no obstacle to consideration of the merits of the case.

2. Statement of Facts

2.1. Established Facts

The following facts relevant to the decision are considered established:

a) The Claimant is engaged in the recycling of scrap and metal waste and the general trade in iron;

b) Fund B… (and its subsidiaries) is a venture capital entity for qualified investors, whose assets are intended to be invested in the acquisition of equity interests in entities with high growth and appreciation potential.

c) Until 2009, Fund B… held the holding company C… SGPS (NIPC …) which in turn held the company D… (NIPC …), which acquired, in 2008, 100% of the capital of the claimant (and another company).

d) D… was formed to embody the acquisition of the capital of A… and its corporate purpose was the collection, storage, recycling and treatment of all types of scrap and waste.

e) In 2008, D… acquired the entire capital stock of A… through: i) bank financing (E…, F… and G…) of €61,200,000.00; ii) financing by shareholder C…, via subordinated loans, in the amount of €36,000,000.00.

g) In 2009, effective as of 1/1/2009, D… merged with A… (and with the involvement of another company, without relevance to the proceedings), in a reverse merger operation, justified by (i) requirement of the financing banks (as is usual in such operations, so that they are secured by the assets and activity of the operating and profitable entity), (ii) cost rationalization and (iii) the reverse merger is carried out because H… had the name, know-how and reputation for the exercise of the activity.

h) Following the merger, the Claimant (surviving company) assumed (i) all of the liabilities of D… and (ii) bore the financial charges (interest) incurred by D… with the Banks and shareholders.

i) In venture capital activity (as developed by group I…) it is usual for the purchase of shares of the company to be acquired to be carried out by a special purpose vehicle established for that purpose (D…) and then a merger to be promoted with the operating entity (H…) – normal or reverse – in order to (i) reduce administrative costs and (ii) by requirement of the Banks (placing the debt in the same legal entity that owns the assets).

j) The AT, in an audit of the Claimant's 2012 Corporate Income Tax return, does not accept that A… may deduct €5,937,546.79 for tax purposes, relating to financing interest originally incurred by D… for the acquisition of A…, whose loans were assumed by it, by virtue of the merger.

l) The AT bases its claim on Article 23º of the Corporate Income Tax Code (CIRC), considering that such financial charges are allegedly not essential for obtaining income or maintaining the source of income and consequently promotes the Corporate Income Tax assessment that is the subject of this arbitral proceeding.

2.2. Unestablished Facts

There are no facts with relevance to consideration of the merits of the case that have not been established.

2.3. Justification for the Determination of the Statement of Facts

The established facts are based on documents submitted by the parties (which are essentially documents issued by the Tax Authority and relating to the merger, by the agreement of the parties (also regarding documents and values and dates of payments) and on official information attached to the proceedings.

3. Legal Issues

3.1. Matter to be Decided

As accepted by the parties, the question arising in these proceedings concerns only the tax treatment to be given to interest and other charges borne, in 2012, by A… relating to loans (from shareholders and third parties) for the purchase of the capital of A… itself and which the claimant bears by virtue of and as a result of the merger with its shareholder D… which originally incurred such debts.

In the opinion of the AT, such interest and charges would not be tax-deductible, pursuant to Article 23º of the CIRC (in the wording and numbering applicable at the time of the facts) because they are not essential for obtaining income or maintaining the source of income. For the Claimant, by contrast, such interest and charges would be tax-deductible by meeting the requirements inherent in Article 23º of the CIRC.

3.2. Applicable Law

According to Article 23º of the CIRC (in the wording and numbering applicable at the time of the facts), the following are considered costs or expenses:

"1. […] those which are demonstrably essential for the realization of income subject to tax or for the maintenance of the source of income, in particular:

(…)

c) Of a financial nature, such as interest on borrowed capital applied in business […], expenses on credit operations […]";

Moreover, with the merger of companies "the incorporated companies are dissolved […], transmitting their rights and obligations to the incorporating company" (Article 112º, para. a), of the Commercial Companies Code).

3.3. Arguments of the Parties

The grounds for the assessment (and the Respondent's response) argue, in summary, that the interest borne by A… following the completion of the merger (and as a result of this operation) relating to financing originally contracted by D… directly for the acquisition of the capital of A… do not merit the nature of essential for income or maintenance of the source of income: after the merger they no longer finance the acquisition of equity interests; there would have to be, in each year in which interest is recorded, a balancing between the financial charges borne and the income and existence of the asset; such interest would not be linked to the normal activity of the claimant and the associated asset does not exist and will not contribute in the future to taxable income.

The Claimant argues, by contrast, that the interest borne in 2012 by A… is essential for income or maintenance of the source of income, and is therefore qualified as a tax cost pursuant to Article 23º of the CIRC; the interest, when initially incurred (by D…), was essential for income and maintenance of the source of income – and if it was at the initial moment, it must be forever, whatever subsequent modifications (even with the merger); the merger, among its normal effects, leads to the economic and tax result of these proceedings; the merger is an operation permitted by commercial and tax law and the AT, in the grounds of the act, does not invoke the alleged abuse of the merger operation, preceded by the acquisition, pursuant to Article 38º, no. 2, of the General Tax Law (LGT).

3.4. Decision

The arbitrators analyzed all the arguments adduced by the parties (in their written submissions and documents and arguments of the respondent), as well as the arguments and consideration of previous arbitral decisions on the subject, but always bearing in mind the minor variations of the case ("each case is unique").

Indeed, various Arbitral Decisions (for example, in proceedings 14/2011-T and 87/2014-T) refused the tax deduction of interest borne by the surviving company post-merger, relating to financing contracted by the absorbed company pre-merger for the acquisition of the capital stock of the future surviving company. By contrast, Arbitral Decisions 101/2013-T, 42/2015-T (here in a non-reverse merger, but the considerations are the same), 92/2015-T and 93/2015-T, 88/2016-T, 491/2016-T, 537/2016-T and 560/2016-T rule in the opposite sense, accepting the deduction of such financial charges, by considering them manifestly essential for obtaining income or for maintaining the source of income.

Furthermore: several of the arbitrators have already ruled in other proceedings on the same subject (proc. 88/2016-T and 491/2016-T) – and decided them in the sense of accepting the tax deduction of such financial charges, even after the merger. In this proceeding, they have re-evaluated all the factual and legal arguments contained in this case and the content of the previous arbitral decisions – and concluded in favor of their previous decisions and the absence of new arguments that would lead them to reverse the sense of their decisions.

After all such consideration, they decide, by majority, in favor of annulment of the challenged assessment and consider that such interest and charges borne by the Claimant are essential for income and maintenance of the source of income of A…, based on the consideration and decision of the Arbitral Decision in proceedings 93/2015-T, to which they adhere and which is reproduced below, the operative part of which is adopted also in this proceeding (which was also done in proceeding 88/2016-T).

(Beginning of quotation from Arbitral Decision in proceedings 93/2015-T)

" […] exclusively at issue are interest on borrowed capital, it is considered that the starting point of the decision-making process in the dispute that must now be resolved is situated within the framework of Article 23º/1/c) of the CIRC.

Such rule provides, among other things and insofar as relevant here, that "Expenses are considered (…) in particular: c) interest on borrowed capital applied in business.".

Thus, and before proceeding to ascertain whether or not the aforementioned rule results in a limitation of the deductibility of interest on borrowed capital, to its application in business, or whether, as concluded in Decision 42/2015-T, interest on borrowed capital applied to other purposes will be deductible within its scope, it is necessary to ascertain whether, in the case, this is or is not the situation that occurs.

In such assessment, and without prejudice to better opinion, one should take into account, as decision-making references, in addition to what has already been duly addressed, four aspects which are considered fundamental, namely:

• The first […] is the circumstance that the equity interests of the surviving company, which formed part of the assets of the absorbed company, do not exist in the assets of the company resulting from the merger process;

• The second, it is considered as unavoidable as the first, is that the "borrowed capital" to which the interest borne and whose deductibility is questioned relates were, at a moment prior to the merger, already fully applied;

• The third, far less evident, but equally unavoidable and relevant, is that the company resulting from the merger process does not materially identify (from the perspective of economic reality) with the company benefiting from the merger, as it was configured prior thereto;

• The fourth, it is considered will not, likewise, be contestable, is that the shares allocated, in the merger process, to the shareholders of the absorbed company, will be consideration, not for the capital obtained by it, by way of the financing whose interest deductibility is at issue, but, as already seen, for the shares of that same absorbed company and which, by force of the merger process, are extinguished.

In light of these references, the conclusion is considered sound that, effectively, in the case the prerequisites of the aforementioned para. c) of no. 1 of Article 23º of the CIRC are met, by the expenses with interest in question corresponding to borrowed capital that was applied in the business of the entity that bears it.

This statement, which at first sight may appear counterintuitive, will be understandable if the third of the fundamental decision-making criteria listed above is duly borne in mind.

Indeed, and as written in the Decision of the Supreme Administrative Court of 13-04-2005, delivered in proceedings 01265/04[1]:

"The merger by incorporation, although it implies that only the company into which the others are incorporated survives, with its own legal personality, does not have as a consequence, in the field of economic and business realities, the disappearance of the merged companies. Some commercial law doctrine – see PINTO FURTADO, PINTO COELHO and PUPO CORREIA in the places cited in the appealed decision – points out that the merged company, losing its legal personality, nevertheless persists, modified, forming a whole with others, in conditions different from those that occurred before the merger. But the same economic reality continues to exist, a same set (now integrated in another, broader set) of means dedicated to a productive activity, which the partners, moreover, wanted to enhance with the merger.

That is, with merger by incorporation, a transformation of the company occurs, but not an extinction, the integration does not result in its disappearance, but in its alteration, even though it implies the loss of legal personality."

Also in the Decision of the Administrative Court of the South of 17-04-2012, delivered in proceedings 04172/10[2] it was written that "the merger of companies is the act by which two or more companies unite their economic forces to form, with the shareholders of all of them, a single collective entity, a new economic and legal subject.

Hence one can affirm, as A. seems to have done, that the merger is, as a rule, and the situation under analysis does not constitute an exception, recommended by interests common to the companies involved in it, and not only to one of them."

And further: "It is true that one could argue that the merged company, losing its legal personality, nevertheless persists, modified, forming a whole with others, in conditions different from those that occurred before the merger; however, it is also true that the same economic reality continues to exist, a same set (now integrated in another, broader set) of means dedicated to a productive activity, which the partners, moreover, wanted to enhance with the merger.

In another formulation, one can affirm that with merger by incorporation a transformation of the company occurs, but not an extinction, the integration does not result in its disappearance, but in its alteration, even though it implies the loss of legal personality.".

Understanding this, it will then be understandable the statement that the expenses with interest in question correspond to borrowed capital that was applied in the business of the entity that bears it. Indeed, properly understood the post-merger reality (not fraudulent), one should accept that the entity resulting therefrom, although contained in the legal "shell" of the surviving company, no longer corresponds to it, as it was configured before the aforementioned process of corporate reorganization, being instead a synthesis between the absorbed company and the surviving company.

Citing the jurisprudence that precedes, it continues "the same economic reality" exists, the "same set (now integrated in another, broader set) of means dedicated to a productive activity", in whose business the borrowed capital whose interest expenses are having their deductibility questioned was applied, since the integration did not result in its disappearance, but in its alteration, even though with the loss of legal personality.

Thus, in light of this understanding of the effects of merger by incorporation – including the reverse form – one cannot conclude otherwise than by the fulfillment of the prerequisites of the aforementioned para. c) of no. 1 of Article 23º of the CIRC.

Thus, it becomes understandable the passage of Decision 42/2015-T cited above, according to which "the merger maintains in the Claimant the financing for which it paid interest, and had as a patrimonial consequence the joining, in the same balance sheet, of the assets that such debt financed and continued to finance. Not financial assets, but their real translation into assets and liabilities of an operational nature". Indeed, the perspective of the aforementioned decision, which is unquestionable in cases of "ordinary" merger by incorporation (non-reverse or upstream), where it is evident that the surviving company exchanges the equity interests it holds for the economic reality into which the participated company translates, should likewise be considered valid in cases of reverse merger, since the material post-merger reality (the "economic reality", the "set (...) of means dedicated to a productive activity"), will be, at least as regards aspects relevant to the problem under discussion, precisely the same[3].

This conclusion is not invalidated, it should be said, by the statement in Arbitral Decision 87/2014-T that "the tax deduction of financial charges incurred (…) must be assessed in the context of the business specific to the Claimant, in view of the normative criteria resulting from no. 1 of Article 23º of the CIRC", and that "to proceed with the application to the case at hand of the requirement of essentiality of costs, it is decisive to ascertain (…) the effective and concrete allocation of the financing for which the interest borne is the remuneration or, in other words, it is important to verify the destination or use of the funds obtained in relation to which the taxpayer claims to deduct tax, for the purposes of determining its taxable profit, the interest and other associated charges borne".

Quite the contrary. Understanding that the Claimant, as it presents itself post-merger, is no longer the same center of interests that existed before that process, but another different one that synthesized with the absorbed company and that, therefore, the business context of the Claimant also incorporates the economic reality previously embodied autonomously by the company absorbed therein, one will be then – truly – assessing the "normative criteria resulting from no. 1 of Article 23º of the CIRC" "in the business context specific to the Claimant".

On the other hand, and as already mentioned, nor does it appear that any alteration has occurred in the "(…) effective and concrete allocation of the financing for which the interest borne is the remuneration" or deviation in the "destination or use of the funds obtained in relation to which the taxpayer claims to deduct tax, for the purposes of determining its taxable profit, the interest and other associated charges borne", since, on the one hand and as seen, the financing was fully applied at a moment prior to the merger, and, on the other and as also already seen, the product of that application was not even diverted to a third party, least of all to the shareholder (before the absorbed company and, later, of the surviving company), insofar as the shares of the surviving company of which the latter became the holder derive, not from the financing whose interest is at issue, but from the shares of the absorbed company that it held, and which were extinguished by the merger process.

The position adopted is likewise compatible with the assertion that can be read in the same decision just referred to, according to which "the fact that certain financial charges are tax-deductible previously in the context of determining the taxable base of a certain company does not mean, by itself, that they necessarily are in the same terms in the context of the company that, by merger, incorporated it".

Indeed, and as already noted by Prof. Teixeira Ribeiro, in light of the Industrial Contribution Code (CCI)[4], the paragraphs of no. 1 of Article 23º of the CIRC cannot be understood otherwise than that when costs or losses are specifically listed in Article 23º, the presumption of their essentiality is presumed, thereby relieving the taxpayer of the corresponding proof, which is precisely the purpose of the enumeration (taken, among other things, from the use of the expression "in particular").

The fulfillment, in the case, of para. c) of no. of Article 23º of the CIRC does not mean that the AT cannot question the general requirement of the deductibility of expenses, contained in the body of the article, by demonstrating that, despite a paragraph of the same being fulfilled (in this case para. c)), the merger was carried out for interests not specific to the business of the companies party to it[5].

Similarly, the AT could demonstrate that, despite a paragraph of no. 1 of Article 23º being fulfilled, and that the merger was determined by interests specific to the companies party to it, the same was carried out in a fraudulent context, in terms of not producing tax effects, as prescribed by Article 38º/2 of the General Tax Law (LGT)[6].

However, in the case, neither of these paths was undertaken by the AT, whereby it will not be incumbent on the Tribunal to assess their soundness.

It is not considered, finally, that the circumstance, also identified above, that, at the moment the interest is borne, the assets in which the borrowed capital was applied do not already form part of the legal sphere of the company resulting from the merger, assumes relevance.

Indeed, once the borrowed capital is applied in business (a situation different from the "diversion" of part of the capital to applications foreign to business interest, which, as already seen, does not occur in these proceedings), it is considered that it would still be possible to refuse the tax deductibility of the corresponding financial charges, by demonstrating (and thus, eliminating the presumption of deductibility arising from para. c) of no. 1 of Article 23º of the CIRC, detected in the wake of Prof. Teixeira Ribeiro), that the product of that application – and no longer the borrowed capital – would have been diverted to purposes outside the business.

What has just been stated will be readily understandable with recourse to the example of a company which, with recourse to borrowed capital, acquires a vehicle, which it dedicates, from the outset, to business within the scope of its activity, but which, from a given moment on, begins to be used exclusively in the interest of third parties (e.g.: shareholders; other companies).

In such a situation, it is considered that the presumption of essentiality of the financial charges incurred with the acquisition of the vehicle, resulting from the application of borrowed capital in the business of the company in question, will be displaced[7], whereby the deductibility of such charges should be refused. However, it is not, once again, such the situation in these proceedings.

Rather, what happens in the situation with which we are concerned is that, by virtue of the merger operation carried out, there was a disappearance of the object of the application of the borrowed capital. That is: such object, which existed, ceased to exist (which is different and, it is repeated once more, is not what happens in the situation sub iudice, of continuing to exist in the sphere of third parties).

Returning to the example of the vehicle, the situation would be the same as would occur in the case of, by virtue of a business decision, it being rendered unusable before the end of the payment period of the financial charges relating to its acquisition (e.g.: the use of it in an advertising campaign that destroys it). Even so, it is believed, such charges will remain deductible, notwithstanding the disappearance – by virtue of a business decision – of the object in which the borrowed capital remunerating them was applied. This would only not be the case, following what has just been said, if it were demonstrated that the decision that led to the disappearance of such object was motivated by interests foreign to the company or, then, that it was abusive. What – once again – is not what is at issue in this proceeding.

It should finally be said that it is considered that the regime relating to the prohibition of financial assistance for the acquisition of own equity interests, essentially regulated in Articles 322º/1 of the Commercial Companies Code, and 23º of the Second Directive 77/91/CEE of the Council, of 13 December 1976, will not invalidate either the decision-making references from which one departed, nor the conclusions that have been drawn.

Notwithstanding such question not having been either a ground of the tax act that is the subject of this arbitral action[8], nor raised by the parties themselves[9], it will always be said, in favor of the integrity of the decision, that one does not perceive that any act has been carried out which, concretely, can be pointed out as having occurred in violation of the aforementioned prohibition.

In fact, the very no. 1 of Article 23º of the Second Directive 77/91/CEE of the Council, of 13 December 1976, in force at the date of the tax fact[10], and in light of which the provision of Article 322º/1 of the Commercial Companies Code (CSC)[11] should, in the case, be read, considers financial assistance the advance of funds, the granting of loans or the provision of guarantees, and it is certain that, in the case, it does not appear that any of these situations has occurred.

Indeed, the funds used for the acquisition of the equity interests of the Claimant were provided by banking entities, and not advanced or granted on credit by the Claimant, and the latter, to the extent that can be ascertained, provided no guarantee to the creditors of the financing used for the acquisition of the aforementioned equity interests, whereby, barring the occurrence of fraud, it cannot be considered that, in the case, the Claimant provided financial assistance, proscribed by the aforementioned rules.

That is, in summary: there are no doubts that funds were not advanced, credit granted or guarantees provided by the Claimant, with a view to the acquisition of own shares. If – and in the case, it is considered, this is a discussion that will not be appropriate to pursue, whereby it will not be relevant whether such is questionable or unquestionable – the same results were obtained by other non-prohibited means, we would then be faced with fraudulent conduct, to be treated as such.

In fact, to consider any violation of the prohibition of financial assistance verified, the same would always have to be withdrawn from the combination of the entirety of the legal acts carried out by the Claimant, and the intention – in that case, fraudulent – to, by that means, obtain a result that the law prohibits.

Indeed, a conclusion of violation of the prohibition of financial assistance by the Claimant will – it is believed – always have to be based on the combination of the complex of acts carried out, from the organization of the group corporate structure initially instituted, to the carrying out of the reverse merger by incorporation, including the financing operation carried out, and it is certain that all such acts, considered in themselves, will appear as lawful and proper to the various business entities involved in them, and only a fraudulent purpose and result effectively demonstrated will be capable of causing the mantle of legality that covers them to fall.

Now, except for better opinion, if then each one of the various legal acts carried out by the different participants in the complex action at issue in this proceeding are lawful and business-like, the proper means of carrying out the aforementioned demonstration, and drawing its effects from it in the tax arena, will be by means of the anti-abuse clause[12].

This conclusion will not, it is believed, be capable of being affected, by means of the consideration – moreover not carried out by the AT itself – of the prohibition of financial assistance in the arena of densification of the general criterion of essentiality of Article 23º/1 of the CIRC, least of all insofar as it is understood that not only would it be necessary, previously, that an effective (and not merely generic or potential) violation of the aforementioned prohibition be demonstrated, but that, being at issue – in the concrete case, as has been said – an overall action of fraud against the law, the use of the general clause of essentiality would constitute – with due respect and, if you will – itself a "fraud against the law", insofar as it would be an expeditious means of subtracting the guarantees that the law intended to confer on the taxpayer, in the cases in which the AT understands that the legal forms used by it do not have correspondence in the economic reality pursued.

In any case, it is also noted that, there being no doubts that in the case a so-called "leveraged merger" ("merger leveraged buy-out", mLBO) took place, no less certain it will be that such figure is known, as of a date that can be considered already long, to the legislator, who – to date – has understood not to withdraw from such knowledge either its general illegalization (there being no knowledge, moreover, that such has occurred in any community legal order), nor any other effects in the tax arena.

Furthermore, in regimes, such as the Italian one, where mLBO operations have already been regulated, the regulation instituted insists especially on communication and audit obligations, thereby evidencing that the operation in itself is not intrinsically illicit and/or fraudulent, but that, uniquely, it contains therein a potential for illicitness/fraud, superior to normal. In such circumstances, it is considered that the simple occurrence of a leveraged merger operation will not, by itself alone, be capable of being considered fraudulent and, least of all, anti-business.

Finally, it will always be said that the application to the case, by means of the general criterion of essentiality of expenses, of the prohibition of financial assistance for the acquisition of own shares, under the argument that all the acts and contracts carried out were characterized by the purpose that it be the assets of the Claimant that bear the cost of the acquisition of its own equity interests, will likewise strike against the finding that the same result would be obtained if the reverse merger by incorporation had been carried out in the opposite sense.

Concluding, and as Prof. Saldanha Sanches[13] noted, if "Operations of division and merger are an area where attempts to obtain tax savings through abusive practices are very frequently verified, which motivates the legitimate concerns of the legislator.", one cannot depart from an "irreparable distrust (...) in relation to the reverse merger, as if this operation could only be carried out to circumvent tax law or was, in itself, an abusive operation".

In such manner, considering that, in the case, the prerequisites of Article 23º/1/c) are met, most of all, that the borrowed capital to which the financial charges whose deductibility is questioned by the AT relate were indeed applied in the business of the Claimant, as it presented itself at the date on which it bore such charges (post-merger), at issue in this proceeding, and that it is not demonstrated (nor did such fact even constitute grounds of the tax acts that are the subject of this arbitral proceeding) that the merger operation, from which resulted the disappearance of the equity interests in which the aforementioned borrowed capital had been applied, was exclusively or mainly motivated by extra-business interests, or fraudulent, the arbitral petitions for annulment formulated should proceed in their entirety.

(End of quotation from Arbitral Decision)

For the sake of clarity, it should be noted that the matter of financial assistance is not properly a subject to be decided, since it was never raised by the AT during the proceedings (nor even subsidiarily). It is addressed only as a mere note suggested by the subject, as indeed was the case in proceeding 93/2015-T.

With the operative part of the decision on the essential question – in the sense of annulment of the challenged assessment, for not violating Article 23º of the CIRC – it becomes unnecessary to rule on the other defects raised by the claimant (alleged violation of the fiscal neutrality regime of the merger, freedom of management, taxation by actual profit, violation of Article 75º-A, of the CIRC and violation of equality and substance over form).

5. Decision

In accordance with the foregoing, this Arbitral Tribunal agrees to rule the petition for declaration of illegality of the challenged Corporate Income Tax and interest assessment for 2012, in the total amount of €982,980.06, as well-founded.

6. Value of the Proceeding

In accordance with the provision of Article 97º-A, no. 1, para. a), of the Code of Tax Procedure and Process (CPPT) and 3º, no. 2, of the Regulations on Costs in Tax Arbitration Proceedings, the value of the proceeding is fixed at €982,980.06.

Notice is hereby given

Lisbon, 6 October 2017

The Arbitrators

José Baeta de Queiroz

Tomás Cantista Tavares

Jorge Carita
(dissenting in accordance with statement attached, which forms an integral part of this decision)

Dissenting Opinion

I voted in the minority, namely because the arguments in support of the thesis of non-essentiality of costs relating to the price that a company pays to acquire itself, did not convince me.

However, I align myself with the first wave of Arbitral Decisions (Proc. 14/2011-T, 87/2014-T) and likewise with the more recent dissenting opinions (Proc. no. 92/2015-T, 93/2015-T and 88/2016-T) which could not discern the absolute essentiality of such expenses, borne in relation to an asset, ownership thereof of itself, unfortunately disappeared upon the merger given its own nature.

It becomes evident that in all these decisions there participated some of the best specialists in tax law currently collaborating with the CAAD.

Regarding the text of this Decision, I have difficulty in accepting, as far as the statement of facts is concerned, that reverse mergers with these purposes are usual in venture capital activity.

I would also consider it "beneficial" if there appeared in the statement of facts the value of the effective interest whose acceptance as a cost is at issue and not only the value of the financing, but adding the usual value of interest borne habitually by the Claimant, in comparison with those it came to have to bear.

In the concrete case, I cannot understand how in a company that showed in the 2008 fiscal year modest monthly financial costs, should pass, after a reverse merger operation of a group (beyond everything that was done before to get there), to bear almost 10 million euros in the first year, which the Tax Authority has to continue to accept as deductible for tax purposes, in the following years and as far as 2012 is concerned, in light of this Tribunal's decision.

It is notable the finding of the evolution of the taxable profit of the Claimant before the merger and after the merger, as appears well in the Tax Inspection Report and which is transcribed here:

| Taxable Base 2005 | €4,761,972.91 |
| Taxable Base 2006 | €8,843,208.32 |
| Taxable Base 2007 | €10,369,376.60 |
| Taxable Base 2008 | €7,645,442.00 |
| Taxable Base 2009 | €234,135.10 |

And to pay the interest owed on the loans incurred by the "parent" to buy the "daughter" and to accept fiscally as a cost of the daughter, is exactly the same as buying raw material to manufacture and sell scrap and metal waste!!!

Everything happens, indeed, as if the activity of the Claimant were its own acquisition, as the AT states in other proceedings in which the same situation is at issue, or rather, the costs "concern its Self-acquisition".

And everybody knows that this is indeed so and that it is proper, it is inherent to any leveraged buyout acquisition (LBO), which constitutes a mechanism used to make inadmissible costs into tax efficiency. (There is no need to apply the General Anti-Abuse Rule (CGAA), it would be enough not to accept these interest as a cost).

And nor should it be said that the character of essentiality of costs should be assessed when the debt is incurred, completely forgetting the moment when interest is effectively borne (farewell to the principle of specialization of fiscal periods, and let alone not speak of the always necessary causal connection between costs and income).

Indeed, I have difficulty accepting that interest incurred by a company to acquire another company into which it itself came to be incorporated, can come to be accepted for tax purposes.

And, if I have no doubts that at the moment the debt was incurred the respective charges were a cost for tax purposes, I do have doubts that they can continue to be after the (reverse) merger and that even more so there are those who understand that if they were at that moment, when they were incurred "they must be forever…" (position of the Claimant in Proc. no. 88/2016-T, p. 7), regardless of the changes that occur, including the merger, even more so reverse (nobody doubts that the merger is an operation provided for in the law and is not at issue here the application of a CGAA, but rather the application of Article 23 of the CIRC).

How can it be stated that "… the expenses with interest in question correspond to borrowed capital that was applied in the business of the entity that bears it" (Proc. no. 88/2016-T, p. 9), when they served so that third parties acquired precisely the company that currently bears them.

I find it hard to understand!!! I confess.

It would be the same as in the context of a corporate restructuring, covered by the benefits of the Tax Benefits Statute in Article 60º, which includes a reverse merger, after the exemptions of Transfer Tax, Corporate Income Tax, etc., interest of identical borrowing would still be considered, as a tax cost of the subsidiary company, that incorporates the parent that bought it.

How can it be stated that the borrowed capital was applied in business by the surviving company, when it did not purchase the capital stock of any other company!!!

It is said that it is important to ascertain "… the effective and concrete allocation of the financing for which the interest borne is the remuneration or, in other words, it is important to verify the destination or use of the funds obtained in relation to which the taxpayer claims to deduct tax, …, the interest and other associated charges borne." (Decision cited, p. 11/12)

But what is the doubt?

Did the financing not serve to pay the acquisition price of the Claimant by the company into which it came to be incorporated. The interest derives from the borrowing of third parties, the debt having been incurred before the merger.

In this way, the company is paying its own shareholders (or part of them, depending on the merger swap ratio) the acquisition price of its own shares.

In the CAAD proceedings that I analyzed and that are dissected in this Decision, I cannot, therefore, fail to subscribe to the Dissenting Opinion subscribed by Dr. António Brás Carlos (Proc. no. 88/2016-T), namely when he manifests his disagreement with respect to the thesis of the continued existence of the surviving company.

In turn, the factual synthesis effected there lays bare the purpose of the entire operation, naturally calling into question that the interest borne can continue to have tax relevance in the post-merger period.

Categorical is point 8 of this dissenting opinion, which I transcribe here, with due deference:

"8. All steps of the operation are inserted in the same "unit of intention and action" and are, from the beginning, uniquely directed to the objective referred to in the previous number. An objective alien to the business interest of the Claimant, the financing not being and the payment of the concomitant charges being necessary to its activity, nor essential for the pursuit of its specific business interest concretized in the production of its income subject to tax or in the maintenance of its generating source. The obligation to pay the charges under analysis was never, from the outset, incurred in the business interest of the Claimant, and it is clear to me that it could not, after the merger, come to be considered that such financing was for it essential for the purposes of no. 1 of Article 23º of the CIRC."

Right has Dr. António Brás Carlos when he states in final summary (point 10) that the decision there in question in that proceeding does not respect, rather starkly contravening, the jurisprudence of the Superior Courts (Supreme Administrative Court/Administrative Court of the South).

"10. In consequence, having regard to the foregoing, the charges relating to such loans, borne by the Claimant, do not meet the requirement of essentiality referred to in no. 1 of Article 23º of the CIRC, because, in summary:

a) They do not relate to the activity carried out by it (Decision of the Supreme Administrative Court, proc. 171/11);

b) The charges corresponding to the interest borne by a surviving company by virtue of the acquisition of borrowed capital by the absorbed company to acquire 100% of the shares of the first, are not essential for this surviving company, because they were not constituted in its business interest, not being, thus, necessary for the pursuit of its corporate purpose (Decision of the Supreme Administrative Court, proc. 164/12 and Decisions of the Administrative Court of the South, proc. no. 5327/12 and proc. no. 8137/14);

c) There is no causal connection between such charges and its income or gains, explained in terms of normality, necessity, congruence and economic rationality (Decision of the Administrative Court of the South, proc. no. 6754/13);"

It is also important, in this context, to take into account the Dissenting Opinion of Prof. João Menezes Leitão in Proceedings no. 92/2015-T and 93/2015-T.

Here is reiterated the reference to the jurisprudence of the Tax Courts which establish that "costs (…) cannot fail to relate, from the outset, to the taxpayer company itself. That is, for a certain sum to be considered a cost of that company it is necessary that the respective activity be carried out by it itself, not by other companies" (Decision of the Supreme Administrative Court of 30.05.2012, Proc. 0171/11).

It is therefore extensive the analysis of the jurisprudence which, making use of the correct reading of the principle of essentiality of costs, results from its application in not meeting the essentiality of those in such Decisions at issue (92/2015-T and 93/2015-T)

"… that such charges do not relate to the activity carried out by the taxpayer company itself, lack relation to the activity pursued by the taxpayer, were not incurred in the interest of the company, in the pursuit of its respective activities, are alien to the company's activity, it is not possible to discern in them any causal connection with its income or gains, explained in terms of normality, necessity, congruence and economic rationality, were incurred beyond the corporate objective, that is, in the pursuit of another interest that is not the business interest." (underlining in original). Is that not enough!!!

I must also agree with Prof. Menezes Leitão when he states that:

"… assuming the indicated financing charges, the Claimant is obliged to divert resources extracted from its assets, which should be destined for the pursuit of its activity and the realization of its corporate purpose, for the payment of the debt and the financial charges relating to the acquisition of equity interests in its capital by others." (p. 62 and 63 of the Decision)

With application ipis verbis to the case in these proceedings!!!

And if the company does not have financial support to bear charges of that amount (millions in interest) and enters insolvency proceedings?!!

"Being thus, the said financial charges do not have a framework in the definition of costs and losses (expenses) for the purposes of determining taxable profit, since the assumption of the charges in question was determined by business motivations within a policy of private interests dictated by those responsible for the interconnected companies and which concerns only them, and, accordingly, such charges should not be deemed essential, in accordance with the provision of Article 23º of the CIRC".

Reason for which I cannot accompany the learned decision delivered.

The well-founded Report of the Tax Authority deserved a better fate.

Lisbon, 6 October 2017

Jorge Carita

(Text prepared by computer, in accordance with Article 131º no. 5 of the Code of Civil Procedure, applicable by remission of Article 29º no. 1 para. e) of the Legal Framework of Tax Arbitration)

[1] Available for consultation at www.dgsi.pt.

[2] Ibid.

[3] Note that one is not here working with a hypothetical scenario in which the merger operation would have to be carried out in other terms. What one is doing is affirming an identity of situations, from the perspective of the topics relevant to the approach of the question to be decided, between the situation verified and another one, regarding which there are no doubts about the answer to be given to the same question.

[4] Commentary on the Decision of the Supreme Court of 9 October 1985, RLJ no. 3743, p. 39-43.

[5] Notwithstanding the circumstance of not constituting a ground of the tax acts in question, the motivation not being business-related of the merger, it will always be said that it is not accurate what was stated by the AT, in the arbitral proceedings, in referring that "The reality of the facts, however, does not allow one to discern the positive effects accruing from the merger for the exploitation of its activity. Rather, on the contrary, it is certain that the funds were not used in the business." (see Article 33º of the response). Indeed, it results from the facts that, prior to the merger, the Claimant bore management expenses, in favor of the company it came to incorporate, expenses which, with the merger, it ceased to bear. A different question, but which, in accordance with the jurisprudence already listed, will escape the scrutiny of the AT, will be to know whether the decision to proceed with the merger was good or bad.

[6] Where, in our opinion, is situated the proper seat for considerations relating to a possible situation of, in fraud of law, placing a company to finance its own acquisition, in violation of the provision of Article 322º/1 of the Commercial Companies Code, and the Second Directive 77/91/CEE of the Council, of 13 December 1976 (Article 23º), in force at the date of the tax fact, as will be developed at the end.

[7] It is considered, thus, that the question of the diversion of the product of the application of the borrowed capital, will be distinct from the question of such application. One thing will be, then, the application of the borrowed capital in the business of the entity that incurred the financing, which, verified, will determine the fulfillment of para. c) of no. 1 of Article 23º of the CIRC, which will produce the respective effects, namely as far as the presumption of essentiality of the expenses "for the realization of income subject to tax or for the maintenance of the source of income" is concerned. Another thing will be the diversion of the product of the application of the borrowed capital, for non-business purposes, which may be relevant, not at the level of the para. c) referred to, but – rather – at the level of the body of no. 1 of the same rule, as an undermining of the presumption arising from that para. c).

The application of capital is what triggers the presumption of essentiality; but the judgment of deductibility is reported on the interest borne. Thus, these will be presumed deductible if the borrowed capital to which they relate was applied in business. This application, however, neither equals nor identifies with the essentiality thereof; it is rather a known fact from which an unknown fact is drawn (presumed): that the financial charges, at the moment they are borne, are borne in the interest of the company. Hence, the demonstration that the product of the application of the borrowed capital was "diverted", in its use, for purposes outside the company, does not mean that, after all, the capital (the borrowed capital) was applied outside business. That demonstration means, rather, that, notwithstanding the borrowed capital having been applied in business, the charges borne, at the moment they are borne, are not borne in the interest of the company, whereby the (presumed) essentiality, in the case and in that period, then does not occur. Thus it is also demonstrated that, in the perspective adopted, the "test of essentiality of expenses", as propounded by the AT, is carried out in "each tax period (...) with this exercise being carried out only at the moment the loan is incurred" (see Article 69º et seq. of the Response). Indeed, the said test is carried out in all fiscal years, notwithstanding the known fact in which the presumption it answers rests, in the first instance, being reported at the moment the loan was incurred.

[8] In fact, as has been repeatedly affirmed by the Supreme Administrative Court, "It is exclusively in light of the grounds stated by the AT when the additional Value-Added Tax assessment was made that the legality of that tax act must be assessed." (Decision of the Supreme Administrative Court of 23-09-2015, delivered in proceedings 01034/11), whereby the Tribunal must adhere, in assessing the legality of the act in question, to the grounds, both factual and legal, stated therein.

[9] It does not appear in the Grounds for Assessment.

[10] Corresponding to no. 1 of Article 25º of the current Directive 2012/30/EU of the Council, of 25 October 2012.

[11] Which, moreover, is contained in the heading "Loans and guarantees for the acquisition of own shares", and proscribes the granting of loans or the provision of guarantees.

[12] When speaking of fraud, here, as in note 16, supra, there will be, it is believed, no overlap between the rule, in the case, of Article 322º of the Commercial Companies Code and of Article 38º/2 of the General Tax Law, insofar as by means of the latter it will be sought to realize the prohibition enshrined in the first, which by a means of fraudulent action may have been formally avoided. Indeed, one thing will be the practice of an act of prohibited financial assistance, which will be null in accordance with Article 322º/3 of the Commercial Companies Code and, as such, will not summon the application of the general anti-abuse clause. Another thing will be situations in which, without any act being practiced in violation of that rule, fraudulently, the same economic results are obtained that it seeks to prohibit. Avoided, in such manner, the legal prohibition, and the nullity thereof resulting, it will be, it is believed, the General Anti-Abuse Clause the proper means of realizing tax legality.

[13] "Reverse Merger and (Tax Administration) Neutrality", Tax Law no. 34 – Journal of Tax Law and Management.