Summary
Full Decision
Arbitral Decision
The arbitrators Carlos Fernandes Cadilha (President), Vera Figueiredo and Augusto Vieira (Members), designated by the Ethics Council of CAAD to form the arbitral tribunal, constituted on 30 May 2018, agree as follows:
I - Report
- A..., S.A., Tax ID Number..., with registered office at ..., no...., ...-... Lisbon, submitted, pursuant to Articles 10 and 2, paragraph 1, letter a), of Decree-Law no. 10/2011, of 20 January, a request for constitution of a collective arbitral tribunal with a view to declaring the illegality of the acts of additional assessment of Corporate Income Tax, as well as the acts of assessment of compensatory interest and the acts of compensation, in the total amount of € 45,739.18, with reference to tax year 2013, and in the total amount of € 44,542.61, with reference to tax year 2014.
The applicant grounds its request as follows.
Following the merger of company B..., Lda. with company C..., Lda., there occurred a global transfer of assets of the merged company to the acquiring company, including all assets and liabilities, with the company assuming responsibility for the charges inherent to the loan agreement no. ... entered into between C..., Lda. and Bank D..., S.A..
The Applicant, previously designated E..., Lda., was transformed into a public company, becoming designated as A..., S.A..
Following a second merger operation whereby the Applicant merged with company B..., Lda., there occurred a global transfer of assets of the merged company to the sphere of the Applicant, including all assets and liabilities, with this company assuming responsibility for the charges inherent to the loan agreement no. ... entered into between the merged company and Bank D..., S.A..
As a consequence of the merger, the Applicant's assets increased substantially, in particular regarding financial investments, tangible and intangible fixed assets, and there was a considerable increase in business volume and profits subject to tax.
In the context of an audit action for declarative control of expenses recorded as financial charges, the Tax Authority concluded that "the two financings had as their purpose the acquisition of capital, with no connectivity to exploitation activity or to the obtaining of profit or maintenance of the productive source", thus disregarding the deductibility of financial charges associated with the loan agreements for tax purposes, with the consequent correction of the Corporate Income Tax assessment.
The Applicant attributes to the assessment acts the defect of lack of reasoning and the defect of violation of law, considering that the reasons determining the non-deductibility of financial charges are not set out in the inspection report and that, in this case, the essential requirements are met for the accounting cost to be accepted as a tax cost: proof of the cost and indispensability for the realization of taxable profits and gains.
In its reply, the Tax Authority invokes the expiration of the right of action, considering that the arbitral request was submitted more than 90 days after notification of the tax assessment acts.
On the merits, the Tax Authority argues that the corrections set out in the inspection report are properly reasoned, indicating the facts and legal provisions that motivated the non-acceptance of the charges as tax costs. Regarding the deductibility of costs, it argues that the financial charges relate to financings that were not applied in the exploitation or activity carried out by the Applicant and were intended only to satisfy payment of the acquisition of its shareholdings to the previous holders of capital of C..., Lda. and B..., Lda., thus not relating to the acquisition of assets or rights necessary for the Applicant's business activity.
- In the course of the proceedings, the meeting referred to in Article 18 of RJAT was dispensed with and, for reasons of expedition and procedural efficiency, use was made of the witness evidence produced in Case no. 606/2017-T, pursuant to Article 421, paragraph 1, of CPC, taking into account that the evidence produced therein concerns the same issues that constitute the subject-matter of the present case although relating to another financial year.
In pleadings, the Applicant replied to the matter of exception raised by the Tax Authority, stating that the deadline for presentation of the arbitral request, as provided in Article 10, paragraph 1, letter a), of RJAT, by effect of the referral made to paragraphs 1 and 2 of Article 102 of CPPT, is counted from the end of the deadline for voluntary payment of the assessments, which ended on 10 January 2018, so the challenge submitted on 16 March 2018 is timely.
On the merits, the parties reiterated their previous positions.
- The request for constitution of the arbitral tribunal was accepted by the President of CAAD and notified to the Tax and Customs Authority in accordance with regulatory procedures.
The collective arbitral tribunal was thus constituted by the present signatories, who communicated their acceptance of the appointment within the applicable deadline.
Thus, in accordance with the provision of paragraph 7 of Article 11 of RJAT, as amended by Article 228 of Law no. 66-B/2012, of 31 December, the collective arbitral tribunal was constituted on 30 May 2018.
The arbitral tribunal was regularly constituted and has material jurisdiction, pursuant to Articles 2, paragraph 1, letter a), and 30, paragraph 1, of Decree-Law no. 10/2011, of 20 January.
The parties have legal personality and capacity, are legitimate and are represented (Articles 4 and 10, paragraph 2, of the same decree and 1 of Order no. 112-A/2011, of 22 March).
The case has no procedural defects.
It is within our competence to hear and decide.
II - Reasoning
Matter of Fact
- The factual matters relevant for the decision of the case are as follows.
A) The Applicant's business purpose is the marketing of pharmaceutical, hygienic and related products, purchase and sale of medical items and other medicinal products, purchase and sale of medicines;
B) On 17 April 2007, there occurred a reverse merger whereby company B..., Lda. merged with company C..., Lda., which held the acquiring company;
C) B..., Lda. held a pharmacy operating license;
D) With the merger there occurred a global transfer of assets of the merged company to the acquiring company, with this company assuming responsibility for payment of the charges inherent to the loan agreement no. ... entered into between the merged company and Bank D..., S.A.;
E) The loan granted to company C..., Lda., in the contracted amount of €1,750,000, had as its purpose the acquisition of 98% of the shareholding in company B..., Lda.;
F) On 31 December 2008, there occurred another merger whereby the Applicant merged with company B..., Lda.
G) With this operation there took place a global transfer of assets of B..., Lda. to the sphere of the Applicant, with the company assuming responsibility for payment of the charges inherent to the loan agreement no. ... entered into between the merged company and Bank D..., S.A.;
H) The loan granted to company B..., Lda., in the contracted amount of €4,499,000.00, had as its purpose the acquisition of shares representing 49.8% of the share capital of company A..., S.A.;
I) The reasons underlying the merger, as set out in the merger plan, were the correction of detected inefficiencies and the elimination of unnecessary costs, namely through:
a) Integration of the administrative facilities of the two companies with consequent cost reductions;
b) Concentration of sales effort, investment and advertising;
c) Overall reduction of the administrative and logistical structures of the two companies through integration of all treasury, accounting, human resources management and general management activities of the acquiring company;
d) Better use and rationalization of existing personnel;
J) Following the merger, the Applicant company increased its assets regarding financial investments, tangible fixed assets and intangible fixed assets, with the value of assets increasing from €1,517,196.38 to €7,925,038.00;
L) From 2008 to 2015 it recorded a gradual increase in business volume;
M) The Applicant was subject to an internal tax audit action for declarative control of expenses recorded as financial charges determined by Service Orders no. OI2016... and no. OI2016..., of the Finance Department of Lisbon, with reference to tax years 2013 and 2014;
N) The inspection report states that, "in the case under analysis, it is verified that the two financings had as their purpose the acquisition of their own capital, with no connectivity to exploitation activity, nor to the obtaining of profit or maintenance of the productive source";
O) On 13 October 2017, the Applicant was notified of the draft Tax Inspection Report and to exercise, if it so wished, its right to prior hearing;
P) On 3 November 2017, the Applicant exercised the right to hearing;
Q) The Applicant was notified of the additional Corporate Income Tax assessment act no. 2017..., the compensatory interest assessment act no. 2017... and the compensation act no. 2017..., with reference to tax year 2013, in which a total amount payable of €45,739.18 was determined, as well as the additional Corporate Income Tax assessment act no. 2017..., the compensatory interest assessment act no. 2017..., and the compensation act no. 2017..., with reference to tax year 2014, in which a total amount payable of €44,542.61 was determined.
R) On 16 March 2018 the Applicant submitted to CAAD the present request for arbitral decision.
The tribunal formed its conviction regarding established facts based on the documents attached to the petition and those contained in the administrative file presented by the Tax Authority with its reply, as well as on the witness evidence produced in Case no. 606/2016 as provided in Article 421, paragraph 1, of CPC. The matter referred to in R) results from the entry record of the request for decision in CAAD's system.
II - Reasoning
Matter of Exception
- The Tax Authority raises the question of expiration of the right of action on the ground that the request for arbitral decision was submitted beyond the 90-day period counted from the date of notification of the contested tax acts, considering that the notifications of the assessment acts took place on 5 and 6 December 2017 and the request for constitution of the arbitral tribunal was submitted on 16 March 2018.
The objection is manifestly unfounded.
The said deadline for requesting constitution of an arbitral tribunal, pursuant to Article 10, paragraph 1, letter a), of RJAT, is counted from the facts provided for in paragraphs 1 and 2 of Article 102 of CPPT, for acts susceptible to autonomous challenge, and likewise from notification of the decision or the end of the legal deadline for decision of hierarchical appeal.
According to the provision in Article 102, paragraph 1, of CPPT, to which this provision refers (paragraph 2 has since been repealed), the challenge shall be presented, in particular, from the "end of the deadline for voluntary payment of tax obligations legally notified to the taxpayer" (letter a)) or from "notification of the remaining tax acts, even when they do not give rise to any assessment" (letter b)).
It is thus clear that the calculation of the challenge deadline is counted, not necessarily from the date of notification of the tax act, but, where there is an assessment and a deadline is fixed for payment of the tax obligation, from the end of the deadline to voluntarily effect that payment.
In the present case, the deadline for payment of the assessments ended on 18 January 2018, so the submission of the arbitral request on 16 March following is timely, as on that date the said 90-day period had not yet elapsed.
Substantive Question
Order of Knowledge of Defects
- The Applicant grounds its request for contentious annulment on a defect of lack of reasoning and a defect of violation of law related to the deductibility of financial charges as a tax cost in application of Article 23 of the Corporate Income Tax Code.
As provided in Article 124 of the Tax Procedure and Process Code, in the judgment to be pronounced in the challenge proceeding, the tribunal shall first consider the defects that lead to a declaration of non-existence or nullity of the contested act and, thereafter, the alleged defects that lead to its annulment (paragraph 1), with the first group subject to consideration of defects whose finding would, in the prudent opinion of the judge, determine more stable or effective protection of the injured interests, and, in the second group, the order indicated by the challenger, provided that the latter establishes between them a relationship of subsidiarity and no other defects are alleged by the Public Ministry or, in other cases, that fixed in the preceding letter (paragraph 2).
In the present case, no defects are alleged that lead to a declaration of non-existence or nullity of the contested act or others resulting from exercise of public action, with only defects leading to annulment of the administrative act being at issue. On the other hand, the Applicant does not indicate a relationship of subsidiarity between the defects, so it appears that there should be priority consideration of the defect of violation of law as it is this that affords more stable or effective protection of the injured interests, since the defect of lack of reasoning – if it were to succeed – would not prevent the Administration from producing, in execution of judgment, an act of identical tenor although properly reasoned.
Deductibility of Financial Charges as Tax Costs
- The Tax Authority corrected the Corporate Income Tax assessment for tax years 2013 and 2014 on the grounds that, pursuant to Article 23 of the Corporate Income Tax Code, the financial charges incurred and recorded by the Applicant arising from bank loans subscribed and realized by C..., Lda. and B..., Lda. are not fiscally deductible.
The transfer of said charges occurred following the successive merger of C..., Lda. by B..., Lda. and of this latter entity by the Applicant, which determined the global transfer of assets of the merged companies to the acquiring company, with all assets and liabilities, and the assumption of responsibility for payment of charges inherent to the loan agreements.
In this context, the Tax Administration argues that, with the mergers, the income generated by the activity of the acquiring company came to bear the costs of acquisition of capital and, in that sense, the funds are not being used in its respective exploitation nor do they constitute a productive source of profits or gains resulting from its business activity, so they do not meet the requirements of indispensability and correlation required by Article 23 of the Corporate Income Tax Code.
In contrast, the Applicant argues that the charges it bears are not only related to its activity but were relevant to the increase in taxable income and as such should be considered fiscally deductible.
The crux of the question to be decided concerns the criterion of indispensability of expenses referred to in the aforementioned Article 23 of the Corporate Income Tax Code.
In the wording in force in 2013, the provision, in the part that is now most relevant to consider, provided as follows:
"Article 23
Costs or losses
Expenses are considered those that are demonstrably indispensable for the realization of income subject to tax or for the maintenance of the productive source, in particular the following:
(...)
c) of a financial nature, such as interest on borrowed capital applied in exploitation, discounts, premiums, transfers, exchange differences, expenses with credit operations, debt collection and issuance of bonds and other securities, redemption premiums and those resulting from application of the effective interest rate method to financial instruments valued at amortized cost.
(...)".
In the wording resulting from Law no. 2/2014, of 16 January, effective from 1 January 2014, paragraph 1 of that provision came to provide that "for the determination of taxable profit, all expenses and losses incurred or borne by the taxpayer to obtain or secure income subject to Corporate Income Tax are deductible", specifying in paragraph 2, by way of example, the expenses and losses covered by this general clause, among which are the expenses of a financial nature referred to in the previous letter c) of paragraph 1, which now corresponds to letter c) of paragraph 2.
It results from this provision, in the wording in force in 2013, that the consideration of costs or losses for tax purposes depends on a requirement of indispensability for the realization of profits or gains that are subject to tax.
In fulfilling the concept of indispensability, there is firm case law understanding that the "legal notion of cost provided by Article 23 of the Corporate Income Tax Code does not result in the Tax Administration being able to call into question the principle of freedom of management, scrutinizing the merit and timeliness of the company's management economic decisions and considering that only those from which profits directly flow to the company or prove convenient to the company can be fiscally assumed. The indispensability referred to in Article 23 requires only a relationship of economic causality, in the sense that it is sufficient that the cost be incurred in the company's interest, in order, directly or indirectly, to obtain profits. And outside the concept of indispensability will fall only acts contrary to the corporate purpose, those that do not fall within the company's interest, above all because they do not aim at profit" (cf. judgment of the Administrative Court of the South of 6 October 2009, Case 03022/09 and, in the same sense, judgment of the Administrative Court of the North, of 12 January 2012, Case 00624/05).
In this same line of understanding, the Supreme Administrative Court, drawing attention to the case-by-case character of fulfilling the concept of indispensability, formulates the following criterion:
"The rule is that properly recorded expenses are tax costs; the criterion of indispensability was created by the legislator, not to allow the Administration to intervene in company management, dictating how it should apply its resources, but to prevent the tax consideration of expenses that, although recorded as costs, do not fall within the scope of the company's activity, were incurred not for its pursuit but for other foreign interests. Strictly speaking, these are not true company costs, but expenses that, in view of their object, were abusively recorded as such. Without the Administration being able to evaluate the indispensability of costs in the light of criteria relating to their timeliness and merit".
With the same judgment concluding that, "under penalty of violation of the principle of tax capacity, the Administration can only exclude expenses not directly ruled out by law under strong reasoning that convinces that they were incurred beyond the corporate purpose, or at least with clear deviant excess, in view of the objective needs and capacities of the company" (judgment of 29 March 2006, Case no. 1236/05).
The doctrine has likewise taken this position.
Rui Morais notes that "the invocation of the rule of indispensability of costs can never be made to substitute judgment regarding the timeliness and merit of charges assumed, as they resulted from the decision of the corporate bodies, with another judgment, also of a business nature made by the tax administration or the courts". And he continues by saying that "we cannot deem good the orientation of certain case law that refuses tax recognition of certain costs because it is not possible to establish a direct correlation with the obtaining of concrete profits. Taken to the extreme such an understanding would mean that expenses with research would only be fiscally deductible when such research was successful, when, as a result thereof, the company began to sell new goods and services (...)."
To conclude in the following manner:
"We argue that the question of whether a cost should or should not be deemed indispensable should be resolved from the objective intent of the transaction, that is from the business purpose test. We believe it is fairly clear what the provision aims at: to refuse tax contribution in some of the charges borne by the taxpayer (...). If the assumption of the charge was preceded by a genuine business motivation (...) the cost is indispensable. When it should be concluded that the charge was determined by other motivations (personal interest of shareholders, directors, creditors, other companies in the same group, commercial partners, etc.) then such a cost should not be deemed indispensable" (Notes to the Corporate Income Tax Code, Coimbra, 2007, pages 86-87).
In the same terms, Saldanha Sanches notes that "knowing whether a certain cost corresponds, or not, to the most effective defense of the company's interests is a question that cannot be resolved by granting the State a power of intervention (...) so as to make a judgment regarding a certain option of business management, just as it cannot validate the qualification of the expense as a cost by making it subject to the condition of subsequent verification of the actual generation of profits" (The Limits of Tax Planning, Coimbra, 2006, page 215).
In summary, in light of the principles just exposed, it should be understood that the business activity that generates deductible costs must be that which translates into operations that have a purpose (and not an obligatory nexus of immediate causality) of obtaining income or the purpose of maintaining the potential of an income-generating productive source. In that sense, productive activity should not be understood in a restrictive sense, but rather in a broad sense, meaning activity related to an income-generating source of the entity bearing the costs. In seeking the meaning of the concept of company activity, it cannot be limited to mere or simple operations of production of goods or services, but presupposes a relationship with the overall economic operations of exploitation or with the operations or acts of management that fall within the proper interest of the entity assuming the costs (cf. in this sense, the arbitral judgment handed down in Case no. 480/2016).
It is within this comprehensive scope that the new wording introduced by Law no. 2/2014 should be understood, which, aiming to implement a greater degree of certainty in the concrete application of deductibility criteria, came to establish as a general principle that expenses related to the activity of the taxpayer incurred or borne by the latter are deductible, reinforcing the idea that connectivity with business activity is sufficient, regardless of the actual contribution to taxable income (cf. Final Report of the Commission for Reform of Corporate Income Tax, 30 June 2013).
- In the present case, as results from the established factual matters, the financings obtained by C..., Lda. and B..., Lda. had as their purpose the acquisition of share capital, aiming to secure, in the first case, majority participation in company B..., Lda. and, in the second case, a 49.8% participation in company A..., S.A..
The reverse merger operations, allowing the acquisition of the acquiring company by the acquired company, meant that the financial charges with the loan agreements borne by the merged entities – which in the meantime ceased to exist – came to be assumed, by effect of the global transfer of assets, by the acquiring company.
It should be noted - as has been stressed by case law – that the merger of companies by merger, although it implies the loss of legal personality of the merged company, does not determine the disappearance of the economic reality that it constituted, which comes to be integrated into the acquiring company by effect of the corporate reorganization (cf. judgment of the Supreme Administrative Court of 13 April 2005, Case no. 01265/04).
And it is in relation to the economic reality as a whole, resulting from the merger, that it is necessary to ascertain whether the charges inherent to financings incurred at a time before the merger, with a view to the acquisition of shareholdings, could have contributed to generating income subject to taxation that, as such, could be deducted for tax purposes under Article 23 of the Corporate Income Tax Code.
What appears determinant, therefore, is not that the liability was constituted to acquire shareholdings of the beneficiary companies, but that such acquisition becomes capable of contributing to the obtaining of taxable income.
As was seen, the first financing was intended to allow the acquisition of an operational company, which held the pharmacy operating license, and the subsequent merger by acquisition between the companies, through the joining of assets and liabilities, made it possible to associate the financial charges connected with the acquisition to the gains resulting from the business activity conducted by the acquired company. The second financing had in view the acquisition of shareholdings of the Applicant, followed by another merger operation whereby this entity merged with the acquiring company.
In this case, it was proved that the objectives underlying the second merger were the correction of detected inefficiencies and the elimination of unnecessary costs, namely through the integration of the administrative facilities of the two companies with consequent cost reductions, the concentration of sales, investment and advertising effort, the overall reduction of the administrative and logistical structures of the two companies through integration of all treasury, accounting, human resources management and general management activities of the acquiring company, and better use and rationalization of existing personnel.
It was also proved that, following that merger, the Applicant increased its assets regarding financial investments, tangible and intangible fixed assets, with the value of assets increasing from €1,517,196.38 to €7,925,038 and from 2008 to 2015 recorded a gradual increase in business volume.
There is thus a connection between the loans made to purchase shareholdings and the growth and restructuring strategy subsequently developed by the acquiring company.
As can be concluded, the increase in the Applicant's assets, by effect of the merger of company B..., Lda., is related to business reasons and enhanced the generation of income and profits. On the other hand, the assumption of charges inherent to the investment previously made by C..., Lda. in the merged company cannot fail to be understood as a necessary consequence of the global transfer of assets, which underlies the considerations of economic rationality that justified the merger. These financial charges cannot, therefore, fail to be considered as related to exploitation.
One could discuss whether a given investment constitutes a normal act of management when, by virtue of a later merger operation, it has in view to allow the deduction by the acquiring company of a liability that originates in the merged company and results from its own acquisition.
It appears, however, that the disregard of tax effects, in this context, could only take place through recourse to the general anti-abuse clause referred to in Article 38, paragraph 2, of the General Tax Law, which, in general summary, presupposes that an artificial or fraudulent act or transaction has been committed that represents the abuse of legal forms and has as its sole or principal objective the obtaining of a tax advantage (on this aspect, António Castro Caldas/J.M Cabral Sacadura, "The Deductibility of Financial Charges in the Context of Mergers and Acquisitions", in Current Legal Matters Úria Menéndez, no. 36, 2014, pages 125-126).
Such a clause, whose application is subject to its own procedure, requiring authorization from the highest-ranking official of the department, prior hearing of the taxpayer and a special duty of reasoning by the Tax Authority (cf. Article 63 of CPPT). This is not the basis of the additional tax assessment acts at issue, which are reduced solely to the disregard of the deductibility of tax costs under Article 23 of the Corporate Income Tax Code.
For all the foregoing, it cannot fail to be recognized that the requirements for deductibility of financial charges as tax costs are met, and the arbitral request must be judged to be well-founded.
It should be noted that the arbitral decision handed down in Case no. 606/2016-T, which concerned identical additional correction acts, with reference to tax year 2012, pronounced in this same sense, and the arbitral decision handed down in Case no. 93/2015-T, whose doctrine was equally followed in Case no. 120/2017-T.
Defects with Knowledge Prejudiced
- Given the solution reached, the defect of lack of reasoning that was also invoked is prejudiced.
III - Decision
Thus it is decided to judge the request for arbitral decision to be entirely well-founded and, in consequence, to annul the additional Corporate Income Tax assessment act no. 2017..., the compensatory interest assessment act no. 2017... and the compensation act no. 2017..., with reference to tax year 2013, with the total amount payable of €45,739.18, as well as the additional Corporate Income Tax assessment act no. 2017..., the compensatory interest assessment act no. 2017... and the compensation act no. 2017..., with reference to tax year 2014, with the total amount payable of €44,542.61.
Value of the Case
The Applicant indicated as the value of the case the amount of €90,281.79, which was not disputed by the Respondent and corresponds to the amount of the assessment that was intended to be challenged, so the value of the case is fixed at that amount.
Costs
Pursuant to Articles 12, paragraph 2, and 24, paragraph 4, of RJAT, and 3, paragraph 2, of the Regulation on Costs in Tax Arbitration Proceedings and Table I attached to that Regulation, the amount of costs is fixed at €2,754.00, which shall be borne by the Respondent.
Let it be notified.
Lisbon, 24 September 2018
The President of the Arbitral Tribunal
Carlos Fernandes Cadilha
The Member Arbitrator
Vera Figueiredo
The Member Arbitrator
Augusto Vieira
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