IRC Fair Value Financial Instruments: CAAD Arbitration on Tax Inspection Validity (126/2015-T)

ARBITRAL DECISION

A..., LDA., with registered office at Rua ..., no. ..., ..., ..., 1495-153 Algés, NIPC ..., requested, in accordance with the law, the constitution of an Arbitral Tribunal, seeking the annulment of the additional assessments (Corporate Income Tax, municipal levy and compensatory interest) nos. 2014 ... and 2014 ..., relating to the tax years 2010 and 2011, respectively, which resulted in an amount to be paid, including compensatory interest, as per statement of account reconciliation, of € 195,938.95 and € 28,980.09, for a total of € 224,919.04.

The Respondent is the Tax and Customs Authority.

The Petitioner, in accordance with the law, elected to designate an arbitrator, appointing Mr. Dr. Fernando Carreira de Araújo to perform such functions. The Respondent designated as arbitrator Ms. Prof. Dr. Ana Maria Rodrigues, with the presiding arbitrator, Mr. Prof. Dr. Rui Duarte Morais, being appointed by consensus between them.

The arbitral tribunal was constituted on 07/05/2015.

The AT presented its response in a timely manner.

The holding of the meeting referred to in article 18 of the RJAT was waived.

By order of 6/11/2015, the period for issuing the arbitral decision was, with grounds, extended by a further two months.

On 10/12/2015, the hearing of witnesses took place, whose depositions were recorded. By consensus of the parties, successive written pleadings followed, which necessitated a further extension of two months to the period for issuing the arbitral decision (minutes of the session of 10/12/2015).

I – REPORT

A) The Legality of the Inspection Procedure

The Petitioner begins by arguing that the inspection procedure which gave rise to the disputed assessments is tainted by a legal defect, leading to its annulment, as it concerns an external inspection initiated on 09.05.2013, before the issuance of the respective service orders, which was only concluded with the final report, notified on 27.10.2014, that is, an external inspection that extended well beyond the six months legally prescribed, in which neither was the final report drawn up within 10 days after the exercise of the right of hearing, nor was its notification to the taxpayer made within the legal period, or, in summary, "an external inspection where none of the legal procedures for its beginning and conclusion were complied with".

Maintaining the characterization of the procedure to which it was subjected as external inspection, the Petitioner argues that the request for the sending of documents via e-mail is equivalent to a physical displacement of AT officials to the taxpayer's premises for the collection of the required elements, being that "the nature of the inspection procedure (with the requirements and consequences inherent to it) stems from the material acts performed, the procedure being external if the elements or documents relied upon by AT were external."

In its response, the Respondent, AT, argues that the requests for the sending of documents were made under the collaboration principle enshrined in article 59 of the General Tax Law (LGT), integrating the preliminary preparation work of the inspection procedure, provided for in article 44 of the RCPITA, being that at the time of this notification the inspection procedure had not yet been initiated, nor even scheduled.

It further argues that the analysis performed resulted from the assessment of coherence of the Financial Statements, including the Appendix, set out in the tax declarations (Form 22 Declaration and IES), and thus the diligences performed were devoid of any investigatory nature of the taxpayer's operational activities and that the inspection acts were performed exclusively in AT services, through formal and coherence analysis of documents, and that no external diligences were performed, whether on the taxpayer's premises or with other entities related to it.

It further concludes that, should it be understood that the inspection procedures were external procedures, the consequence would still not be the voidability of the assessments in question, but merely the existence of irregularities that do not invalidate the assessment acts.

B) The Measurement of Financial Assets

The Petitioner held in portfolio, in 2010 and 2011, a set of securities which, in accounting and tax terms, it recognized at fair value through results, which in the years in question resulted in very large negative variations (losses) (losses due to reductions in fair value).

The AT did not accept the fair value measurement adopted by the Petitioner in the accounting of such securities, arguing that the amortized cost model should be used in such measurement. This divergence in measurement models to be adopted gave rise to the disputed assessments.

The AT disagrees with the application of the fair value model in the measurement of the securities in question on the basis of two lines of reasoning: (1) the erroneous classification of these financial products as being held for trading and (2) the fulfillment of the criteria set out in the applicable accounting standard – NCRF 27 – which would determine their measurement according to the amortized cost criterion.

Moreover, the AT understands that, if the accounting treatment of such assets initially adopted by the Petitioner is considered correct, they should have been subject to accounting reclassification due to there having been an alteration in the circumstances that determined the initial classification, with the impossibility of reclassification not being "consistent with the real decisions of companies, which can modify their acquisition strategies for financial instruments and with the qualitative characteristics that financial information should provide to its users, and moreover could open the door to tax arbitrage, given the difference in applicable regimes".

C) Indemnification for Guarantee Costs

The Petitioner further requests, in the event of the success of the present contestation, to be indemnified "for the totality of costs incurred with the guarantee provided, plus interest at the legal rate, calculated on such costs and counted from the dates in which they were incurred until the date on which authorization is given for the lifting of the guarantee, without dependence on the period for which the guarantee is to be maintained, in accordance with article 53 of the LGT".

The request for arbitral ruling is timely, the parties are legitimate and duly represented, there are no nullities or exceptions requiring determination, and the joinder of claims (e.g., the annulment of the Corporate Income Tax assessments relating to 2010 and 2011) is legal in light of what article 3, no. 1, of the RJAT provides, since it concerns, essentially, the assessment of the same factual circumstances and the same legal principles or rules.

II - ESTABLISHED FACTS

Based on the elements in the case file (administrative case file, facts agreed upon by the parties, testimony of witnesses and reliable and uncontested documents), the following facts relevant to the decision are considered established:

a) The AT, through consultation of the IES declaration (Simplified Business Information), verified that the Petitioner reported as expenses for the tax years 2010 and 2011 fair value reduction adjustments relating to financial investments of, respectively, € 2,176,954.88 and € 1,383,439.00 without having added them to taxable profit in section 07 of the Form 22 declaration.

b) The assets (financial instruments) and the losses accounted for by the Petitioner relating to them were, in 2010:

c) And in 2011:

d) Invoking the collaboration principle, the AT, on 09/05/2013, notified the Petitioner to proceed with the sending of tax-relevant elements that would make it possible to assess, in particular, the identification of instruments/investments accounted for at fair value, whose adjustments were recognized in the profit account, as well as other clarifications, namely regarding the accounting entries made in connection with the transition from POC to SNC.

e) The taxpayer sent by e-mail, on 20/05/2013, the requested elements, including, among other elements, analytical trial balances, before and after the calculations relating to 31.12.2010 and 31.12.2011, extract of the accounts recording the entries in the accounting of transition adjustments and fair value losses, as well as copies of the documents for the acquisition of the bonds acquired in 2010 and 2011 and their respective technical sheets, which constituted the totality of its financial investments.

f) On 31/05/2013, a partial scope internal inspection was initiated for "control of fair value adjustments in financial assets" relating to the tax year 2010.

g) This was followed, beginning in September 2013 and until June 2014, by an exchange of correspondence, via e-mail, within the scope of the said procedure, through which the AT requested new documents and the Petitioner satisfied such requests, as per the following table:

h) On 17/06/2014, a partial scope internal inspection was initiated for "control of fair value adjustments in financial assets" relating to the tax year 2011.

i) On 04/08/2014, the Petitioner was notified of the draft corrections to the internal inspection report, relating to both years in question, being granted a period of fifteen days to exercise the right of prior hearing.

j) Alleging the complexity of the matter, the taxpayer requested the extension of the right of hearing from 15 to 25 days, which was denied.

k) On 20/08/2014, within the 15-day period that had been set for it, the Petitioner exercised its right of prior hearing, presenting arguments that were partially accepted, as will be seen below.

l) The Petitioner was notified, dated 27/10/2014, of the final inspection report.

m) Of the losses accounted for by the Petitioner in the tax year 2010, relating to the financial instruments enumerated in b), in a total of € 2,176,754.88, the AT only accepted the deductibility of € 161,624.88, making the correction amount to € 2,015,330.00, excluding the part relating to transition adjustments which will be addressed below.

n) Of the losses accounted for by the Petitioner in the tax year 2011, relating to the financial instruments enumerated in c), in a total of € 1,383,439.00, the AT only accepted the deductibility of € 388,629.00, making the correction amount to € 994,810.00, also excluding the part relating to transition adjustments.

o) This is because, as regards both 2010 and 2011, the AT did not accept as tax-deductible the losses recorded by the Petitioner (see above b) and c)) relating to the Bonds ... Income B…, Bonds ... Global Income, Bonds ... Income C…, Bonds ... Banking Income and Bonds ... Income G….

p) These assets are accounted for in the account "financial assets held for trading".

q) These assets were held by the Petitioner for periods exceeding one year.

r) In all cases, the return of these investments, both as to their repayment and the payment of interest, depended on factors or risks (of performance and solvency) of third parties vis-à-vis the issuer of the bonds (...).

s) The Petitioner acquired these financial products with the intention of reselling them in the short term, it not being its intention to make a permanent or medium to long-term investment, but rather an application of treasury surpluses, thus of the short term.

t) Such securities were not alienated in the short term because, following their acquisition, they suffered significant losses in value, which determined that the management body had opted for their maintenance in portfolio in the hope of a future reversal of the losses.

u) Corrections were also made by the AT to the transition adjustments from POC to SNC made by the Petitioner relating to the following securities, in a total value of € 32,650, in each of the years 2010 and 2011, relating to negative net variations:

v) Finally, as a result of the exercise of the right of hearing, the AT accepted a positive correction in favor of the Petitioner relating to a gain of € 199,440 resulting from the disposal of 600,000 bonds ... Income C…, corresponding to 50% of the 1,200,000 bonds held, occurring in the tax year 2011, vis-à-vis the fair value recorded in accounting in the tax year 2010.

x) Thus the correction relating to the tax year 2010 amounts to € 2,047,980 (2,015,330 + 32,650); and

y) The correction relating to the tax year 2011 amounts to € 828,020 (994,810 + 32,650 – 199,440).

z) The Petitioner provided a bank guarantee to obtain the suspension of execution of the disputed assessments.

All these facts, with the exception of s) and t), are documentary proven, namely in the A.P. attached to the case file; the fact established as proven in r) results from the analysis of the technical sheets of the products in question, contained in Annex VI of the Tax Inspection Report.

For the proof of s) and t), there concurred, in addition to the respective accounting entries, the testimony of the witnesses called by the Petitioner, which, in the understanding of the Arbitral Tribunal, responded with impartiality and truth to what was asked of them, having convinced the Tribunal that the financial assets in question were acquired by the Petitioner as a form of application of available treasury funds, which would be (and were) necessary to finance new investment projects, there being no intention to hold them to maturity, and, furthermore, that the recording of such financial applications did not undergo alterations as a result of the entry into force of the SNC, as they had already previously been accounted for as assets held for trading.

However, these securities ended up being held for a period longer than foreseen at the date of acquisition, given the strongly negative evolution of the value of these securities in the market or resulting from their valuation. The difficult situation of the country at the time of the facts also forced a postponement of the new investment projects the Petitioner intended to undertake, thus maintaining the liquidity referred to above.

No facts claimed to be unproven relevant to the proper decision of the case were alleged.

III - QUESTIONS TO BE DECIDED

From the above, there are four questions to be decided:

a) The legality of the inspection procedure, namely to determine whether it was an external or internal inspection and, should the former characterization be concluded, what are the consequences of the procedural irregularities invoked by the Petitioner.

b) The correctness of the accounting of the financial assets in question and, consequently, of their measurement at fair value, as done by the Petitioner, and the tax relevance of the losses due to fair value reduction thus determined.

c) The legality of the corrections made by the AT relating to the transition adjustments from POC to SNC.

d) The right of the Petitioner to be indemnified for costs incurred with the provision of guarantee.

Article 124 of the CPPT provides that, where there are defects leading to the annulment of the contested act and there are no claims formulated on a subsidiary basis (as is the case), the court shall assess as a priority the defects whose substantiation the court determines, according to the prudent discretion of the judge, to result in more stable or effective protection of the injured interests.

Where substantial defects of the assessments and formal defects of the inspection procedure leading to them are in question, it is important to determine those in the first place, not least because the substantiation of the latter would not prevent, at least in the abstract, the renewal of the disputed assessments.

IV - THE ACCOUNTING OF THE FINANCIAL INSTRUMENTS IN QUESTION

1 - NCRF 27 and Recognition of Financial Assets

NCRF 27 regulates the difficult matter of the recognition and measurement of financial assets, attempting to establish general principles and, only, some precise rules to guide their accounting.

This standard is part of one of the most specialized areas of financial accounting, starting from a classification of complex contours. This is, moreover, recognized by the AT, in article 52, at the end, of its Response, where it refers to "matters that prove to be of great accounting and tax complexity".

It is important to begin by analyzing some issues that prove fundamental to the development and understanding of the themes addressed in this decision.

Two of the concepts that are central for this purpose are: initial recognition and subsequent measurement of financial instruments.

Thus, an entity should recognize a financial asset or a financial liability only when that entity becomes a party to the contractual provisions of the instrument, and these should be measured, at initial recognition, at their fair value (§§ 11 of NCRF 27; §§ 14 and 43 of IAS 39 and § 11 of IAS 32)[2] which generally corresponds to acquisition cost.

The classification of financial assets is based on the perspective of the holder of the instrument.

In generic terms, NCRF 27, like IAS 39[3], divides financial assets into four broad categories – financial assets held for trading; financial assets that at the moment of initial recognition are designated by the entity at fair value through profits or losses; investments held to maturity; financial assets available for sale – establishing for each of them a specific regime of initial recognition and measurement and, above all, of subsequent measurement, that is, different rules of accounting during the temporal period of holding of these instruments.

Financial assets held for trading are those acquired mainly with the purpose of sale in the near term. Financial assets available for sale, on the other hand, are those financial assets not derivative that are designated as available for sale or that are not classified as a) loans granted or accounts receivable, b) investments held to maturity or c) financial assets at fair value through profits or losses.

These two sets of assets should always be measured in the accounts for the period[4] at their fair value. Annual variations in fair value, whether positive or negative, are reflected, respectively, in revenues and expenses of the entity holding these financial assets (regardless of their realization or sale), contributing to the result of each of the periods or to the so-called other comprehensive income (to which are added the recognition of gains and losses in equity).

Investments held to maturity include assets that have a fixed maturity, being that the entity that holds them has the positive intention and the ability to hold them to their end or termination, reasons for which it does not qualify them as available for sale. These assets should be measured at amortized cost, using the effective interest method, less any reduction for impairment, if there is objective evidence of such loss.

2 - The Nature of the Financial Instruments at Issue

Let us now analyze the financial instruments in question in the present case: the first conclusion is that they should not be qualified as bonds or non-convertible bonds, as provided in articles 348 and 360 of the Commercial Companies Code (CSC) and article 1, no. 1, let. b), of the Securities Code (CVM), and should be integrated into other groups of securities or products.

Bonds are securities that give their holders (subscribers or subsequent holders) a right of credit against the issuing company, the remuneration of which is effected via interest (fixed, variable, supplementary), with obligation of capital repayment in a period fixed from the initial moment. Convertible bonds, on the other hand, may be transformed into shares, by decision of the creditor, and under the conditions provided for in the issuance prospectus.

The investments under analysis cannot be identified as bonds, as defined above, as they are complex products, whose remuneration depends on other financial instruments. This is because the contracts/prospectuses relating to them take into consideration underlying assets or other collaterals in fixing the rules relating to their repayment and remuneration.

In reality, the purchase contracts entered into by the Petitioner, relating to the securities in question, contain clauses that may result, for the holder, in loss of the nominal value and accrued interest, far beyond the typical cases of credit risk of so-called normal bonds. Clauses providing that, upon non-performance (or other situations designated as credit events) of one or more reference entities, the issuer has the right to avoid, partially or totally, the payment of capital and accrued interest, even if it has conditions to make the payment.

These securities may thus, for these reasons, decrease in value and investors are expressly warned that they should be prepared to bear the loss of their entire investment. It is also stated in the generality of the prospectuses of these financial products that potential investors should understand that the return of their investment in the securities will depend on the performance of the underlying assets/collateral assets, considered as a whole.

In summary, in financial terms, these securities contain Credit Default Swaps on other entities.

Reason for which they are structured products, within the meaning of CMVM Regulation no. 1/2009.

3 - Holder's Intention and Classification

From the accounting standpoint, it is important to consider, for purposes of classification and initial recognition, the intention of the investment holder at the date of acquisition: to know whether he acquired the "products" in question with the intention of holding them to maturity or whether he intended to acquire the assets with the intention of, at any time, trading them or holding them for sale.

If the perspective has been one of these, the accounting standard (national and international) points to recognition at fair value, and in subsequent measurement, fair value variations should be recognized in the results[5].

If the investor's intention is to hold the acquired instruments to maturity, with capacity to hold them to their end or termination, and provided there is no risk of capital loss, the measurement criterion to be applied will be amortized cost.

4 - IAS 39 and Subsequent Measurement

To better understand this point, NCRF 27, it is important to resort to IAS 39, which our NCRF 27 was inspired by. In the international standard (IAS 39) the issue of recognition and subsequent measurement is much more clearly regulated. Thus, and following closely IAS 39, it can be stated that financial assets should be classified in one of the following four categories, as already referred to above (§ 9 of IAS 39):

Category I: At fair value, through results, when these are assets held for trading and designated by the entity.

Category II: Available for sale.

Category III: Investments held to maturity.

Category IV: Loans granted and accounts receivable.

As for subsequent measurement, it is closely related to or dependent on the categories where each financial asset and financial liability come to be classified at the moment of its acquisition, and taking into account the objectives of holding by its holder at that date.

Subsequent measurement of financial assets, according to IAS 39 (§§ 45-47), shall be done as follows:

5 - The Basis for Classification: Holder's Perspective, Not Product Characteristics

It is stated in the Inspection Report, p. 31, that in NCRF 27 "(…) as well as all the new regulatory framework determines that what is relevant in the selection of the most appropriate measurement model are the characteristics of the products/assets".

The AT is mistaken. The understanding of the international standard is not that, and therefore neither is that of the SNC. From IAS 39 it is clear that financial assets are defined from the perspective of the holder of the instrument[6]

This is because the standard-setter calls for a measurement that depends on the designation of the instruments at the date of contract execution and because, when referring to financial instruments that can be measured at cost or amortized cost, it merely makes an enumeration of the instruments that can be measured according to that criterion (§ 14 of NCRF 27), appealing to a residual categorization for the remaining financial instruments - see § 15 of the same standard, when it refers that an entity must measure at fair value all financial instruments that are not measured at cost or amortized cost in accordance with paragraph 12 with counterpart in results. Thus a bond that is acquired to be held to maturity should be classified in financial investments – Account 415.1 – Other financial investments – held to maturity" and measured at amortized cost. A portfolio of bonds that the entity acquires with the perspective of trading it in the secondary market shall necessarily be classified as liquid financial means – 14.31 - Other financial assets (fair value through results).

The very wording of NCRF 27 contradicts the AT's understanding that what is relevant in the selection of the most appropriate measurement model are the characteristics of the products/assets. See, for example, that bonds appear both in the examples of assets to be measured at amortized cost (in which case the standard-setter designates them as "investments in non-convertible bonds" - see let. b) of § 14), as well as in the list of assets to be measured at fair value (in which case the same appear designated as "Perpetual debt instruments or convertible bonds" - see let. c) of § 16). In this case a bond by the fact of being convertible is presumed to be held to maturity, and already a non-convertible bond, which can by the will of its holder be traded in the secondary market, is indicated as belonging to the examples of instruments that can be measured at fair value.

It is further important to note that for an instrument to be classified as measured at amortized cost, NCRF 27 requires the cumulative fulfillment of the three conditions listed in its § 13:

"A financial instrument may be designated, in accordance with paragraph 12(a), to be measured at amortized cost IF IT SATISFIES ALL THE FOLLOWING CONDITIONS[7]:

(a) Be on sight or have a defined maturity;

(b) The returns to its holder be

(i) of a fixed amount;

(ii) of a fixed interest rate during the life of the instrument or of a variable rate that is a typical market indexing for financing operations (such as Euribor) or that includes a spread on that same indexing;

(c) Not contain any contractual clause that may result for its holder in loss of the nominal value and accrued interest (excluding typical cases of credit risk).

As we saw previously, the securities under analysis here do not fall within the category of convertible bonds, nor in the category of bonds proper (non-convertible bonds), and have associated risks of loss of nominal value and accrued interest not associated solely with the credit risk of the issuer. The return, if any, of the investment in the securities will depend on the performance of the underlying asset, considered as a whole. Thus, it is easy to see that it cannot be the nature of the security that determines its classification and measurement, but the intention with which it was acquired and the risk that the investor is willing to run with the investment made. If the asset was acquired with the intention of being held to maturity, the standard-setter designates it as an investment and integrates it into class 4 - Investments, categorizing it as a non-current asset. However, if the intention is trading (held for sale) designates them as a financial instrument, and integrates them within the scope of class 1 - Liquid financial means, presupposing that these securities can be quickly transformed into cash or cash equivalents.

6 - Structured Products and Classification

As we have seen, NCRF 27 only expressly refers to the types of most common bonds (non-convertible bonds and/or convertible bonds) and not to structured products, such as those held by the Petitioner, as these do not possess the typical characteristics of either of those two types of bonds.

Moreover, one can perfectly understand that the type of instruments in question "fit" in the examples presented in the NCRF relating to instruments to be measured at fair value, given that they will not necessarily fit in the instruments measured at amortized cost, as to belong to that group they would have to cumulatively meet all the conditions provided for in § 13 of NCRF 27, and the structured products in question have high levels of risk and do not have capital repayment guaranteed in all situations; the return of these products is associated with and dependent on other assets/collaterals.

From the reading of § 15 of NCRF 27 there might, eventually, result the idea that amortized cost would be the first measurement criterion to test. In this understanding, when one intended to classify an instrument for purposes of initial and subsequent measurement, it would be important to first verify whether that instrument should be measured at amortized cost or at fair value.

Without discussing the merits of such an understanding, let us adopt it for the sake of logical discipline.

For an instrument to be measured at amortized cost, NCRF 27 requires the full verification of the three conditions listed in its § 13:

"A financial instrument may be designated, in accordance with paragraph 12(a), to be measured at amortized cost if it satisfies all the following conditions[8]:

(a) Be on sight or have a defined maturity;

(b) The returns to its holder be

(i) of a fixed amount;

(ii) of a fixed interest rate during the life of the instrument or of a variable rate that is a typical market indexing for financing operations (such as Euribor) or that includes a spread on that same indexing;

(c) Not contain any contractual clause that may result for its holder in loss of the nominal value and accrued interest (excluding typical cases of credit risk).

Now, as we have seen, the contracts entered into by the Petitioner, relating to the securities in question, contain clauses that may result, for the holder, in loss of the nominal value and accrued interest, far beyond the typical cases of credit risk of so-called normal bonds (and which are different from Credit Default Swaps on other entities). Thus there must be concluded that the requirement in let. c) of § 13 of NCRF 27 is not met, and therefore, differently from what the AT understands, the invocation of this accounting standard alone does not allow the conclusion that the accounting by the Petitioner of such "products" is erroneous. Besides, the AT accepts that the products in question involve risks that go beyond typical cases of credit risk of so-called normal bonds, except it considers that such risks (differently from what would happen with the financial investments enumerated in b) and c) of the established facts whose fair value accounting was accepted) are limited, which, as we have seen, does not correspond to the reality expressed in the technical sheets of the securities in question.

7 - Examples are Not Exhaustive

There is further to be taken into account the following: the fact that NCRF 27, in its paragraph 14, presents a listing of financial instruments that should be measured at amortized cost does not mean that there are no more products that can and should be valued by this measurement criterion, nor that the type of instruments presented as examples must necessarily be, in all cases, measured at amortized cost.

This is merely an exemplary enumeration.

Thus, for example, the fact that in let. b) of § 14 of the NCRF reference is made to "Investments in non-convertible bonds" does not oblige that an investment in non-convertible bonds must be measured at amortized cost if the intention of its holder is to transact these instruments in the secondary market, in which case the same should be classified as held for trading or available for sale, and therefore should be measured at fair value. It is a well-known fact that today, with the globalization of markets, many of these securities are usually transacted in the secondary market as a way to give liquidity to this type of security for its holder.

8 - Fair Value as the General Rule

Let us now analyze the provisions of § 15 of NCRF 27: An entity must measure at fair value all financial instruments that are not measured at cost or amortized cost in accordance with paragraph 12 with counterpart in results.

Fair value is thus assumed to be the general rule of measurement of financial instruments, which can only be departed from when, unquestionably, circumstances exist that oblige recourse to another measurement method.

9 - Assets Held for Trading

In § 16 of NCRF 27 we find examples of financial instruments that should be measured at fair value through results.

For what concerns us, it provides:

"(d) Financial assets or financial liabilities classified as held for trading. A financial asset or a financial liability is classified as held for trading if it is:

(i) Acquired or incurred mainly for the purpose of sale or repurchase in the very near term;

(ii) Part of a portfolio of identified financial instruments that are managed together and for which there is evidence of having recently achieved actual profits."

It was precisely on the basis of this standard that the Petitioner accounted for at fair value the financial instruments in question.

In reality, in the absence of a legal obligation to proceed otherwise as a result of the provisions of other standards, as we have seen above, it must be agreed that the "financial products" held by the Respondent fit within let. d) of § 16 of NCRF 27, since, as was proven and results from, from the start, the accounting characterization operated by the Petitioner, such assets were acquired with the purpose of sale in the very near term, and therefore should be measured at fair value through results.

It is important to emphasize here that, beyond the presumption of truth that legally assists the accounting entries and the fact that such intention was corroborated by the testimony of the witnesses called by the Petitioner, the fact is that the AT alleged no facts intended to demonstrate that such was not the initial intention of the Petitioner when acquiring such financial instruments, sustaining the contrary only in the holding of the securities for a period exceeding one year, i.e., in a judgment made in hindsight.

10 - Reclassification of Financial Instruments

Admitting the possibility that the initial classification of the "products" in question proves correct, the AT raised another question: being this classification based on the intention at the date of acquisition, and verifying that such intention was not fulfilled (since the financial instruments in question were not alienated in the short term [one year], they should have been reclassified in accounting terms, which would determine that their measurement would then be done at amortized cost.

In support of this thesis, the AT invokes IAS 39, and NCRF 4, paragraph 12, let. a), according to which an entity must change its accounting policy if it results in the fact that the financial statements provide reliable and more relevant information about the effects of transactions, other events or conditions, on the financial position, financial performance or cash flows of the entity.

Now, we have that, in the first place, NCRF 27 does not fix any maximum temporal period for the holding of "assets acquired for sale". It is not, therefore, the mere fact that the entity holds them for periods greater or lesser that would oblige accounting reclassification.

More relevant is that, for this type of situations (subsequent measurement of a financial asset or liability), there is an express rule in § 17 of NCRF 27: an entity must not alter its policy of subsequent measurement of a financial asset or liability while such instrument is held, whether to begin to use the fair value model or to cease using that method.

That is, the accounting requalifications of financial assets, with the consequent changes in measurement criteria used, are legally excluded. We are faced with a special rule that, as to its field of application, excludes the invocation of general rules that, possibly, might provide otherwise.

§ 17 of NCRF 27, in not allowing the reclassification of financial instruments, aims to prevent accounting manipulations in an area that can have serious repercussions on the financial situation and performance of an entity[9].

The taxpayer classified the acquired financial instruments as held for trading with the perspective that it held them for, at any moment, being able to come to alienate them. Once the initial classification has been made, the AT cannot subsequently invoke that the classification should be altered because the bonds were not traded in the same period in which they were acquired, or in a short period of time, which, moreover, would always be irrelevant as what counts is the intention at the moment of acquisition[10].

11 - Tax Relevance of Fair Value Adjustments

The AT argues that "admitting that reclassification cannot be effected when there is an alteration in the circumstances that determined the initial classification, would not be consistent with the real decisions of companies, which can modify their strategies for acquiring financial instruments and with the qualitative characteristics that financial information should provide to its users, and moreover could open the door to tax arbitrage, given the difference in applicable regimes.

We understand the AT's viewpoint. In reality, accounting today rests, at times, on estimates and prognostic judgments that contain within themselves a margin of evaluation. There also dominates a broad set of general and indeterminate concepts, identical to those present in the generality of the most influential accounting frameworks in the world. It is recognized that the entity that prepares the accounts possesses, at times, some discretionary room, with the objective of better reflecting economic and financial reality (by nature, complex).

It is accepted that such may not be in accordance with the principles that traditionally govern taxation, namely the principle of typicality of tax law. In reality, by adopting accounting standards as the basis for the determination of taxable profit (model of partial dependence), the "margin of discretion or opportunity" of the account preparer has a direct translation into the tax to be paid in each tax year.

But this cannot be confused with any form of "abusive tax planning", not least because – referring to the concrete case - the Petitioner, at the initial moment in which it proceeded to the accounting treatment of the instruments in question, necessarily did not know whether the measurement at fair value would be fiscally advantageous (generating deductible expenses in the years in which it held them) or disadvantageous (generating, in those years, unrealized taxable revenues), as this would always depend on the future quotation of such securities in the market.

Nor can it be considered "abusive" the decision to defer the moment of sale of such securities, relative to what was initially foreseen, given that a significant decrease in its market value occurred. Such a decision corresponds to the normal (to the expected) behavior of a good manager, being dictated by reasons that are manifestly not of a tax nature but of a financial nature: hope for appreciation of the security and thereby recovery of losses, or even realization of gains.

In any event, the tax to be paid, considering the set of tax years that mediate between the acquisition and alienation of the instruments in question[11], will be the same, it will merely be different the amount to be paid in each tax year (a difference which - we accept - can be significant, as happens in the concrete case).

What is important to point out is that the tax legislator could have departed from the accounting rules, but did not do so regarding financial instruments measured at fair value, having accepted as relevant from the tax perspective what is provided for in accounting, with respect to this species of securities in concrete[12].

Now, for this Arbitral Tribunal to decide according to the law in force, no relevance can be given to the criticisms, however possibly well-founded, that may be made to the legislative choices.

12 - Article 18 of the CIRC

The provision of the CIRC that directly concerns this issue is article 18, no. 9, which provides:

"Adjustments resulting from the application of fair value do not contribute to the formation of taxable profit, being allocated as revenues or expenses in the tax period in which the elements or rights that gave rise to them are alienated, exercised, extinguished or liquidated, except when:

a) They relate to financial instruments recognized at fair value through results, provided that, where it concerns equity instruments, they have a price formed in a regulated market and the taxpayer does not hold, directly or indirectly, a holding in the capital equal to or greater than 5% of the respective equity capital; or

b) Such is expressly provided for in this Code.

(…)."

The legislator accepted the tax relevance of fair value variations in financial instruments without any additional requirement, without any departure as to their accounting treatment, as stated above.

Since, as we have concluded, from the accounting standpoint the classification made by the Petitioner should be accepted, as it falls within the margin of "choice" left by NCRF 27 to the preparers of accounts, then the tax treatment will be that which proves adequate from the accounting standpoint, in homage to the principle of partial dependence (of the determination of taxable profit in relation to accounting profit) that prevails in our tax system, as per article 17 of the Corporate Income Tax Code, and therefore the Petitioner's claim should be granted.

V - THE TRANSITION FROM POC TO SNC

The AT also analyzed the accounting entries made by the Petitioner relating to the transition from POC to SNC, relating to the assets in question (see u) of the established facts), not having accepted the fair value variations accounted for in the year of that transition, for the same reasons set out above, and therefore did not accept the negative values moved in the account of retained earnings relating to the tax years 2010 and 2011, concerning the bonds ... Global Income and ... Income B… held since 2009.

Let us first recall that the transition rule, NCRF 3 – First-time adoption of NCRF - allows the recognition and measurement of financial instruments in accordance with no. 2, let. f) and no. 5, let. i) of the Appendix to that rule. The combination of these rules with the transitional provision provided for in article 5 of Decree-Law no. 159/2009, of 13 July, determines that the variations resulting from first-time adoption of the NCRF contribute, in equal parts, to the formation of the taxable profit of the first tax period in which those rules are applied and the 4 subsequent tax periods.

However, in the present case what is not questioned is the correctness of the accounting adjustments made by the Petitioner in the transition from POC to SNC, but rather the assumption that underlay such adjustments.

Understanding that the financial assets in question should not be measured, after entry into force of the SNC, according to the fair value criterion, the AT understood, logically, that no adjustments should have been made (any losses recognized) in the "transition".

That what is not in question is the correctness of the accounting procedure followed by the Petitioner is evident from the fact that the AT objected to nothing as to such "transition", as it was done by the Petitioner, regarding the financial assets that, at that date, it had in portfolio as to which the AT accepted that their respective measurement should be done at fair value.

Thus, this question of the "transition" has no autonomy, does not raise any different questions that need to be assessed. Understanding the Arbitral Tribunal to be correct the measurement of such assets at fair value, after entry into force of the SNC, the losses relating to them recorded by the Petitioner in the "transition" are also to be accepted, since the AT nothing objects as to the manner in which, concretely, it was done, and therefore, in this particular as well, the Petitioner's claims should be given effect.

VI - DEFECTS OF THE INSPECTION PROCEDURE

Since the Arbitral Tribunal concluded for the total substantiation of the application for annulment of the disputed assessments, by considering the corrections to taxable amounts made by the AT illegal, the necessity for determination of this question becomes moot.

VII - COSTS OF GUARANTEE PROVISION

The Petitioner petitions, in the event of success of its contestation, to be indemnified "for the totality of costs incurred with the guarantee provided, plus interest at the legal rate, calculated on such costs and counted from the dates in which they were incurred until the date on which authorization is given for the lifting of the guarantee, without dependence on the period for which the guarantee is to be maintained".

No doubt arises as to the fact that, being official assessments tainted by voidability, we are faced with error attributable to the Services, which confers on the Petitioner the right to be indemnified in accordance with article 53 of the LGT.

However, as is established jurisprudence, the right to indemnification for unwanted provision of guarantee does not entail, in any situation, the right to indemnatory and/or default interest, in accordance with articles 43 and 102 of the LGT, being limited, solely, to the value corresponding to the costs actually incurred with the provision of the same, albeit with the limit provided in no. 3 of the abovementioned article 53 of the LGT (Decision of the STA of 2011-03-30, proc. no. 013/11).

Whereby the Petitioner's application to be indemnified for the costs it incurred with the provision of such bank guarantee proceeds, necessarily to be determined in execution of judgment, up to the limit provided in no. 3 of article 53 of the LGT, the application for such amount to be increased by legal interest not proceeding.

VIII - DECISION

Therefore, hereby decide, unanimously, the arbitrators:

a) Annul, by illegality, in their entirety, the disputed assessments;

b) Condemn the Respondent, AT, to indemnify the Petitioner for the costs that the latter incurred with the provision of bank guarantee to prevent execution of the disputed assessments, in an amount to be determined in execution of judgment, up to the limit provided in no. 3 of article 53 of the LGT, the application for the amount of costs incurred to be increased by the respective legal interest not proceeding.

c) Not determine, by irrelevance, the other grounds of the application.

The value of the case is set at € 224,919.04 Euros.

Costs by the Petitioner, in accordance with article 5, no. 2, of the Regulation of Costs in Tax Arbitration Proceedings.

Lisbon, 1 February 2016

The Arbitrators

(Rui Duarte Morais)

(Fernando Carreira de Araújo)

(Ana Maria Rodrigues)

[1] The Inspection Report refers to these securities, but we believe this to be a lapsus, being in question the bonds ... Global Income as the accounting account referred to is 141242045703. Moreover, otherwise one would not understand the different treatment for gains and losses on the same security.

[2] A large portion of financial instruments continue to be measured at fair value by imposition of the accounting standards in force, before and after the crisis. However, it is acknowledged that the issue is not settled, and therefore the debate on fair value accounting has intensified, particularly in the post-economic and financial crisis witnessed since 2008.

[3] A financial asset or financial liability at fair value through profits or losses is a financial asset or a financial liability that satisfies any of the following conditions.

a) It is classified as held for trading. A financial asset or a financial liability is classified as held for trading if it is: i) acquired or incurred mainly for the purpose of selling or repurchasing it in the very near term, ii) part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent actual model of short-term profit taking, or iii) a derivative (except in the case of a derivative that is a financial guarantee contract or a designated and effective hedging instrument);

b) At the moment of initial recognition it is designated by the entity at fair value through profits or losses.

c) Investments held to maturity are non-derivative financial assets with fixed or determinable payments and fixed maturity that an entity has the positive intention and ability to hold to maturity.

d) Financial assets available for sale are those non-derivative financial assets that are designated as available for sale or that are not classified as a) loans granted or accounts receivable, b) investments held to maturity or c) financial assets at fair value through profits or losses.

[4] Commonly referred to as Financial Statements (FS).

[5] If the Petitioner had chosen to use the international standards (IAS 39; IAS 32; IFRS 7), as is permitted by § 2 of NCRF 27), from October 2008, it could even be discussed whether fair value variations should be recognized in results or in equity. However, and for the issue to be decided it is not relevant to this alternative allowed by IAS 39, as it was the taxpayer's choice to use NCRF 27.

[6] For financial liabilities and equity instruments, these are defined from the perspective of the issuer of the respective instrument.

[7] Emphasis ours.

[8] Emphasis ours.

[9] On the difficulties of the said reclassification, see Maria Anunciação Bastos / Lúcia Lima Rodrigues and Joaquim Carlos Pinho, "Financial Instruments at fair value - Changes Resulting from the Crisis", XV Congress on Accounting and Auditing, Accounting and the Public Interest, 11 and 12 June 2015, Instituto Superior de Contabilidade e Administração de Coimbra and OTOC, Coimbra. In this article, pp. 8 and 9, it is stated that: "In 2008, and especially after the failure of some banks, the problems related to fair value accounting were predominant (Fiechter, 2011). According to the European Banking Federation (EBF, 2008, point 5) 'the pro-cyclical nature of fair value measurement appears to have worsened the impact of the crisis on financial and non-financial companies. It is vital that the standard-setting bodies take up the issue and seriously consider changing the rules of fair value accounting'.

The IASB began to face pressure from EU leaders and finance ministers to analyze the existing differences regarding the rules for reclassification of financial assets according to IAS/IFRS and the FASB normative (US GAAP, more permissive on this subject). This pressure was made to prevent European entities adopting IAS/IFRS from being disadvantaged compared to their international competitors. (Fiechter, 2011).

In that sense, and in response to the requests received, the IASB amended, on 13 October 2008, IAS 39 and IFRS 7 to allow, in exceptional circumstances, to expand the spectrum of reclassifications of financial assets and, in this way, reduce the differences between IAS/IFRS and US GAAP and produce high quality financial information for investors in any global capital market (IASB, 2008). Entities could effect such reclassifications retroactively from 1 July 2008.

Two days after the publication by the IASB of the amendments to IAS 39 and IFRS 7, the EU proceeded to its endorsement [Through Regulation (EC) no. 1004/2008, Commission, 15 October 2008], and all entities of the Member States adopting IAS/IFRS could effect the reclassifications of financial assets in light of the recent amendments, retroactively from 1 July 2008. Never before had the EU endorsed a change to its accounting standard in such a short space of time. The justification for this fact (presented by the Commission upon publication of Regulation (EC) no. 1004/2008, which endorsed these reclassifications) was related to the context of financial turbulence and the existence of financial instruments that ceased to be traded or whose markets became inactive or disturbed, so the amendments had to enter into force as a matter of urgency.

The amendments introduced in IAS 39 at the level of reclassification of financial assets […] are only applicable to non-derivative financial assets and those not designated at fair value through profits or losses at the time of initial recognition and if a set of criteria is met. The reclassification of derivatives and financial instruments designated at fair value through profits or losses is not permitted (IAS 39, § 50b)".

[Emphasis ours].

[10] The same would occur in the inverse hypothesis if the asset had been acquired with the intention of being held to maturity and were sold after 2 months. Still its measurement (at amortized cost) would have been correctly effected, unless the alienation were revelatory of the inability ab initio to hold the asset, albeit the accounting and tax impact would be identical, occurring acquisition and alienation in the same tax year.

[11] Occurred at least partially in 2011 and in 2012, in this case already outside the inspection period.

[12] Already not as regards equity instruments, in certain conditions.