CAAD 151/2018-T: IRC Income Additions, Expense Additions & Provisions for Temporary Work Companies

ARBITRAL DECISION (consult full version in PDF)

I – Report

1. On 26.03.2018, the Claimant, A..., S.A., legal entity no. ..., with registered office at Street..., no..., Porto requested the CAAD to constitute an arbitral tribunal, pursuant to article 10 of Decree-Law no. 10/2011, of 20 January (Legal Framework for Arbitration in Tax Matters, hereinafter referred to only as RJAT), in which the Tax and Customs Authority is the Respondent, with a view to declaring the illegality of the Additional Assessment of Corporate Income Tax (IRC), no. 2016... and Statement of Account Adjustment no. 2016..., relating to the tax year 2012, as well as the Decision Dismissing the Gracious Complaint submitted by the Claimant, dated 12.12.2017, issued by the Head of Finance, by delegation of powers from the Director of Finance of Porto through Decision no. .../2017, of 28.03.2017.

2. The request to constitute the arbitral tribunal was accepted by the Honourable President of CAAD and notified to the Tax and Customs Authority.

Pursuant to the terms and effects of the provisions in no. 1, article 6, of the RJAT, by decision of the President of the Deontological Council, duly communicated to the parties within the legally applicable time limits, the signatory was appointed as arbitrator, who communicated acceptance of the office to the Deontological Council and to the Centre for Administrative Arbitration within the regularly applicable time limit.

The Arbitral Tribunal was constituted on 7.06.2018.

1. The grounds presented by the Claimant in support of its claim were, in summary, as follows:

• The Claimant is a Temporary Work Agency, operating under the framework established by Decree-Law 260/2009, of 25 September, which is engaged in the activity of temporary assignment of workers for use by third-party users.

• Under the aforementioned framework, the employment relationship strictu sensu is maintained between the Worker and the Temporary Work Agency. For its part, the Temporary Work Contract is the service provision contract concluded between a User and a temporary work agency whereby the latter undertakes, for remuneration, to place at the disposal of the former one or more temporary workers who remain subject to the powers of direction and organization of the User.

• In accordance with the aforementioned framework, within the scope of its activity, the Claimant concludes with its Clients (legally referred to as "Users", as defined in article 2/h of Decree-Law 260/2009, of 25 September) Temporary Work Contracts, adopting one of the following modalities:

  • Contracts in which the amount invoiced to Users does not include payment of compensation for termination, with the Claimant assuming the obligation to pay the respective compensation for termination of the employment contract (hereinafter "CPE"), with such payment subsequently invoiced to Users.

  • Contracts in which the amount invoiced to Users includes payment of compensation for termination.

• On the basis of the legal and contractual provisions inherent to the employment contracts concluded with workers as well as based on the history of CPE payments, the Claimant calculates monthly the amount to invoice to its Users, making the adjustments (increases or decreases) that prove necessary by reference to the previous month's allocation.

• For accounting purposes, the Claimant recognizes the amounts to be received from Users as income for the period in the accounting headings 72 - Service Provision as counterpart to account 27 - Other Accounts Receivable and Payable, with the respective adjustments, positive or negative, being recognized in the same accounts.

• In the tax period 2012, the adjustments made throughout the year resulted in a decrease in the amounts previously recognized totalling € 249,552.61, with such adjustment reflected in the accounts through a debit entry (credit with negative value) in account 72 (as counterpart to a credit entry in account 27).

• During the tax period in question, the Claimant was under the obligation to bear the payment of legal charges arising from the termination of various employment contracts concluded for a definite or uncertain term, concluded with temporary workers, being possible to calculate under that same legislation the CPE owed to each employee with considerable precision.

• It is important to note that, as a consequence of the activity carried out by the Claimant, the turnover and number of its employees is quite high, so that the payment of the CPEs in question is, given the accumulated knowledge over years in the performance of its activity, assumed as certain, notwithstanding that there is slight uncertainty as to its exact value and payment date.

• In none of the situations did the Claimant consider that it should recognize accountably a provision relating to the CPE that by legal requirement it would have to bear, in accordance with paragraph 10 of accounting standard NCRF 21.

• Given the certainty of the legal obligation to pay CPE already presented above and the passing on of such amounts to Users, by reference to the latter, the Claimant recognized the income associated with the amounts to invoice to its clients.

• The TA made an arithmetic correction to the Claimant's taxable profit, by reference to the tax period 2012, because it considered that the Claimant had incurred in an "incorrect accounting of the legal obligation related to the termination of employment contracts".

• The Claimant absolutely disagrees with the theory defended by the TA that the debit adjustment in account no. 72 - Service Provision - constitutes a provision, being clear to the Claimant that the degree of uncertainty regarding the timeliness and the amount of CPEs to be paid to workers contracted by it (and to be received from Users in cases where the CPE is invoiced to them) is extremely reduced.

• However, the payment of the said amounts is temporally defined and the respective amount is, in accordance with the law, determinable on the basis of criteria objectively provided for in the Employment Code, and at the time of signature of the contract, the Claimant is able to reliably estimate the termination of the temporary employment contract, based on what is stipulated in the contract itself and in the legal provisions that limit its duration – provisions that are mandatory under article 339 of the Employment Code.

• Without prejudice to the considerations presented above that clearly demonstrate the lack of relevance of the reclassification of the adjustments in question as provisions, it transpires that, upon detailed analysis of the movements underlying the adjustment in question, the Claimant ultimately concludes that, strictly speaking, the accounting entry made as a debit in account 72 – Service Provision is nothing more than the mere reduction of an amount, in excess (by reference to the date of the facts), recorded as a credit in that same account in previous years.

• In other words, this accounting entry is nothing more than, due to the circumstances of the Claimant in 2012, the reversal of income fully taxed for IRC purposes in previous tax periods.

• In order to understand the accounting rationale that led the Claimant to record in 2012 adjustments in the total amount of € 249,552.61 with negative sign as credit in account 72 (which corresponds to a reduction in income), it is important to clarify the following:

• In a given tax year, the Claimant calculates the value it will invoice to its Users in compliance with type A) contracts.

• The Claimant conducts, each month, an analysis of the need to increase or decrease the amount recorded as income in account 72 for the period in question, making the respective adjustments, whenever they prove necessary in accordance with the objectively defined criteria.

• In the light of those adjustments - and in an atypical manner taking into account the history of adjustments made in recent years by the Claimant - the overall adjustment in 2012 consisted of the reduction of the amount to be received from Users in the overall amount of € 249,552.61.

• Such adjustment concerns the difference between the allocation considered as at 31 December 2011, totalling € 388,606.32, and the amount of income to be derived calculated by reference to 31 December 2012, totalling € 139,053.65.

• This accounting adjustment as a debit in account 72 was recorded as counterpart to a credit entry in an account for other debtors (account 272111 - CPE Invoicing), where the CPE amount to be invoiced to clients is recorded.

• In that the movement in account 272111 is counterparted by account 72, it is clear that the allocation considered in December 2011 in the amount of € 388,606.79 was fully subject to taxation for IRC purposes in the years in which it was recorded.

• As such, the Claimant makes an adjustment to income actually recorded and fully taxed for IRC purposes in the past.

• The accounting movements carried out by the Claimant are recorded in accordance with the applicable accounting standards, reflecting all operations carried out, and are organized informatically.

• Given all that has been set out, there is no doubt that the correction proposed by the TA is not due and is in clear violation of various principles shaping the tax-legal order, such as the principle of legality, the principle of taxation on actual profit and the principle of ability to pay, and is therefore vitiated by a breach of law, such that the additional IRC assessment resulting from the TA's correction to the year 2012 must therefore be annulled.

On the other hand:

• Being the tax act in question ostensibly injurious to the interests and rights of the taxpayer, the TA was under a special duty of substantiation, by legal requirement.

• It is settled that the TA must set out the factual and legal premises upon which the decision that it is to make rests, and as is clearly stated in the Decision of the Supreme Administrative Court of 09-09-2015, handed down in the course of case no. 01173/14, "The TA has the legal duty to substantiate acts of assessment (see article 268 of the CRP, as well as articles 21 of the CPT, 125 of the CPA and 77 of the LGT).

The substantiation, even if done by reference or in abbreviated form, cannot fail to be clear, congruent and to consider the factual and legal aspects that permit understanding the cognitive and evaluative process followed by the Administration in the determination of the act."

• The cognitive process followed by the TA is, however, not perceptible for a normal declarant, when faced with the justification presented by the TA, would have serious doubts as to the content and scope of the mental work performed by the TA, particularly with regard to the classification of the nature as a "provision" of the adjustment of € 249,552.61 disclosed as a debit in account 72 – Service Provision.

• It should be declared that the act dismissing the Gracious Complaint is illegal and, consequently, the Additional Assessment of Corporate Income Tax (IRC), no. 2016... and Statement of Account Adjustment no. 2016..., relating to the tax year 2012.

1. The ATA – Tax and Customs Authority, called upon to respond, contested the Claimant's claim, defending itself by impugnation, in summary, with the following grounds:

• Within the scope of temporary employment contracts it concludes with its clients, these may assume two configurations, with respect to compensation for their termination:

A) Contract with the client that does not cover such termination, with CPE paid by the Claimant subsequently invoiced to Users.

B) Contract in which the compensation for termination is included in the amount invoiced to Users.

• In the first case (contracts in which termination is not covered by them), it is found that the Claimant assumes the obligation to reimburse the worker for employment precariousness compensation (hereinafter CPE) corresponding to termination as determined by the Employment Code, with the CPE paid by the Claimant subsequently invoiced to Users.

• At the time of signing the contract with the client, with respect to this obligation undertaken by the Claimant, it is in no way known neither when it will occur nor what amount the said compensation will be;

• Thus, and considering the knowledge it has of the activity it carries out, the Claimant company understood that it should ascertain an estimate, as a matter of prudence, so that accountably, there would be disclosed a liability of uncertain timing and quantification;

• In light of this factuality, it was found that at the end of the 2012 fiscal year the total income derived was reduced in the amount of €249,552.61, resulting from these adjustments;

• In view of the analysis of the nature of the operations carried out, the Inspection Services concluded that provisions appeared to be in place that were not recognized as such in accounting terms;

• Further having concluded that the incorrect accounting of the legal obligation related to employment contract termination resulted in an incorrect determination of the taxable profit for the period;

• Thus, given the characteristics of the adjustments made by the Claimant in the amount of €249,552.61, to secure these compensations, it was important to assess the accounting recognition that it made to verify whether these could or could not be accepted as expenses for the period.

• Now in accordance with § 8 of accounting standard NCRF 21 – Provisions, Contingent Liabilities and Contingent Assets, "a provision is a liability of uncertain timing or amount" that is, it is a liability that is characterized by uncertainty regarding the concrete moment of its occurrence or the amount necessary for its settlement.

• Being an obligation arising from the Employment Code itself, it would have been foreseeable, at the balance sheet date, that an expense would be attributable to the period for the obtaining of benefits, all the more so that given the knowledge of the activity, the Claimant proposed accountably an estimate that it considered reliable for the constitution of said adjustment.

• In fact, this same understanding appears to be shared by the Claimant, when it understands that it should ascertain an estimate, as a matter of prudence, so that accountably there would be disclosed a liability of uncertain timing and quantification, and which is reflected in the accounting documents, for example: "estimate adjustment".

• Thus, the company's accounting omitting the liability associated with a legal obligation, its financial statements do not contain some of the attributes that are configured as qualitative characteristics required by the SNC, namely reliability and a faithful representation, particularly because, in the first place, the balance sheet does not reflect in a true and fair manner the patrimonial situation of the Claimant.

• Note that, instead of having reduced income (by making a negative entry as credit to account 72) the Claimant should have accounted for an expense in account 67 – Provisions for the period, being certain that, in arithmetic terms, the value of net profit is the same, it is also certain that some of its different components do not present the values they should, the credit balance of account 72 is diminished from its real value and the value of a part of the expenses of the period was omitted, with regard to provisions.

• The incorrect accounting of the legal obligation related to employment contract termination resulted in an incorrect determination of the taxable profit for the period, the "estimates" should have been recorded accountably as provisions, since they were intended to meet an expense attributable to the period, but of future verification, or already verified but of uncertain amount, which is manifestly assumed by the Claimant when it says that "it is able to reliably estimate the termination in the contract itself and in the legal provisions that limit its duration".

• The Claimant, in addition to not having complied with the formal requirements of the SNC in accounting terms, did not comply with the provisions of tax law, for whether it recorded in account 72 as credit with negative sign, as it did, or whether it had correctly proceeded by recording as debit in account 67, it would always have to increase that amount in section 7 of tax return form 22, because such provisions do not fall within any of the sub-paragraphs of article 39 of the CIRC.

1. Verifying that no situation existed as provided for in article 18, no. 1, of the RJAT, which would require the arbitral meeting provided for therein, the holding of the same was dispensed with, on the basis of the prohibition of performing useless acts.

The holding of arguments was also dispensed with, pursuant to article 18, no. 2, of the RJAT, "a contrario".

1. The tribunal is materially competent and is regularly constituted in accordance with the RJAT.

The parties have legal personality and capacity, are legitimate and are legally represented.

The proceedings do not suffer from defects that would render them invalid.

1. It is necessary to resolve the following issues:

a) Illegality of the assessment due to a defect of breach of law.

b) Illegality of the assessment due to a defect of substantiation.

II – The relevant factual matter

1. The Claimant is a Temporary Work Agency, operating under the framework established by Decree-Law 260/2009, of 25 September, which is engaged in the activity of temporary assignment of workers for use by third-party users.

2. In accordance with the aforementioned framework, within the scope of its activity, the Claimant concludes with its clients temporary work use contracts, adopting one of the following modalities:

A) Contracts in which the amount invoiced to Users as the price of the service provision does not include payment of compensation for termination.

In these contracts, the Claimant assumes the obligation to pay the respective compensation for termination of the employment contract, with such payment subsequently invoiced to Users.

B) Contracts in which the amount invoiced to Users as the price of the service provision includes payment of compensation for termination.

1. In the cases mentioned in A) of the preceding number, the Claimant bears the expense of CPE, with no amount being invoiced to Users for this purpose, with the CPE paid by the Claimant subsequently invoiced to Users:

2. On the basis of the legal and contractual provisions inherent to the employment contracts concluded with workers as well as based on the history of CPE payments, the Claimant calculates monthly the amount to invoice to its Users, making the adjustments (increases or decreases) that prove necessary by reference to the previous month's allocation.

3. For accounting purposes, the Claimant recognizes the amounts to be received from Users as income for the period in the accounting headings 72 - Service Provision as counterpart to the (sub)account 2721 – Debtors for Accrued Income, with the respective adjustments, positive or negative, being recognized in the same accounts.

4. In the tax period 2012, the adjustments made throughout the year resulted, globally, in accounting terms, in a decrease in income previously recognized in the total amount of € 249,552.61, with such adjustment reflected in the accounts through a debit entry (credit with negative value) in account 72 (as counterpart to a credit entry in account 2721).

5. In 2016, the Tax and Customs Authority (TA) conducted a Tax Inspection procedure with respect to the Claimant, for the tax year 2012, of a general nature, with the respective final report including, in particular, the following:

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1. Following the report, the Respondent issued the assessment sub judice from which it appears that the amount of tax loss determined during the tax period 2012 would not be € 483,512.07 (four hundred and eighty-three thousand, five hundred and twelve euros and seven cents), as self-assessed by the Claimant, but € 233,959.46 (two hundred and thirty-three thousand, nine hundred and fifty-nine euros and forty-six cents).

2. On 30.03.2017, the Claimant submitted a gracious complaint against this tax act, the content of which, contained in the administrative file, is hereby fully reproduced for all legal purposes.

3. The gracious complaint was dismissed by decision issued on 12.12.2017 by the Head of the Finance Service of Porto..., by delegation of powers from the Director of Finance of Porto, the content of which, as well as the information and opinion accompanying it, is hereby fully reproduced for all legal purposes.

With relevance to the decision of the cause, there are no unproven facts.

1. The Tribunal's conviction as to the decision on the factual matter was based on the documents contained in the file, as well as on the arguments presented, with no disagreement between the parties as to this matter.

-III- The Applicable Law

1. Given that the impugning party invoked the illegality of the assessment acts due to breach of law, but also due to insufficient substantiation, legally equated with lack of substantiation, it is necessary to determine the order of knowledge of the defects, observing, as is settled, that provided for in article 124 of the CPPT, applicable by virtue of article 29, no. 1, al. a) of the RJAT (See Jorge Lopes de Sousa, Commentary to the Legal Framework for Tax Arbitration, in GUIDE TO TAX ARBITRATION, Coord. Nuno Villa-Lobos and Mónica Brito Vieira, 2017, Almedina, page 205).

The defect of breach of law is that which would lead to "more stable or effective protection of the interests offended" in that its possible procedence would prevent the renewal of the act, which does not occur with a hypothetical annulment resulting from the defect of lack of substantiation.

In accordance therewith, the Tribunal will first assess the defect of breach of law attributed to the assessment.

1. At the origin of the disagreement under examination are accounting entries of the Claimant in account 72[1], as credit, in the large majority with negative sign, with the balance between entries of positive sign and negative sign being favorable to the latter in the amount of 249,552.61 €, as counterpart to entries, of equal value, as credit, in account 2721.

Class 7 of the SNC Chart of Accounts "Includes the income and gains relating to the period"[2]. Specifically, account 72 "relates to work and services provided that are appropriate to the objectives or main purposes of the entity.(…)The accounting to be carried out should be based on invoices issued or on external documentation (…) while not failing to record revenues for which the corresponding external evidence has not yet been received".[3]

Accounts 272 "(…) record the counterpart of income and expenses that should be recognized in the same period, even though they do not have binding documentation, whose income or expense will only occur in subsequent period or periods."[4] This account contains sub-accounts 2721 and 2722, depending on whether it is debtors for accrued income or creditors for accrued expenses.

In account 2721 "is recorded, as debit, as counterpart of the respective income account, the amount of income attributable to the current period, but whose actual income or receipt occurs in subsequent periods"[5]

The accounting entries consisting of credit variation with negative value in account 7211 as counterpart to credit entry in account 2721 result in the accounting and tax elimination of income that the Claimant had previously recognized (by estimate). Substantially, they are equivalent to debit entries in an income account, and to credit entries in an account of third parties which, in this case, mean the accounting reduction of liabilities of third parties to the Claimant.

It is manifest that the Respondent, in the substantiation of the tax act under examination, bases its entire argumentative line on the non-relevance for tax purposes of hypothetical increases in expenses allegedly represented by those accounting entries.

It should be said, straightaway, that this assumption does not occur. It would have been verified if it were the movement of sub-account 2722 at issue, where is recorded "as credit as counterpart of the respective account of expenses, the amount of expenses or losses attributable to the current period but whose actual maturity or payment occurs in subsequent periods."[6] However, that is not what happens. It was not this account that the Claimant moved nor any account of expenses, but rather account 2721.

It is a manifest error of the justificatory discourse of the Tax Inspection Report, which structures its entire argumentation on supposed expenses with compensations to workers for employment precariousness ("CPE") which according to the Respondent would not be relevant for tax purposes because they allegedly constitute non-deductible provisions, when in reality the entries in question concern patrimonial facts also related to the same compensations, but of opposite sign: amounts to be received (income) from clients of the Claimant in function of the compensations to be paid by the latter to the workers which - rightly or wrongly - were accountably "eliminated" by the Claimant, with the entries in question.

The Claimant, in the administrative phase, contested the position of the Respondent on the ground that it was a matter of accrued expenses and not of provisions, apparently accepting the erroneous assumption that the correction concerned disregard of expenses.

In the request for arbitral pronouncement, despite maintaining this argumentative line in the first part of the request for arbitral pronouncement, it further alleges:

"Now, it transpires that, upon detailed analysis of the movements underlying the adjustment in question, the Claimant ultimately concludes that, strictly speaking, the accounting entry made as a debit in account 72 – Service Provision is nothing more than the mere reduction of an amount in excess (by reference to the date of the facts), recorded as a credit in that same account in previous years.

In other words, this accounting entry is nothing more than, due to the circumstances of the Claimant in 2012, the reversal of income recognized in previous years.

This income which, for tax purposes, was fully taxed for IRC purposes in previous tax periods (i.e., in the tax periods in which such income was considered for accounting purposes).

(…)

Such adjustment concerns the difference between the allocation considered as at 31 December 2011, totalling € 388,606.32, and the amount of income to be derived calculated by reference to 31 December 2012, totalling € 139,053.65.

(…)

In that the movement in account 272111 is counterparted by account 72, it is clear that the allocation considered in December 2011 in the amount of € 388,606.79 was fully subject to taxation for IRC purposes in the years in which it was recorded."

Now, regardless of the compatibility of these two argumentative lines, the Claimant is correct when it concludes that the entries made in account 72 are decreases in the amount recorded as credit in that account (decrease in income).

This decrease, as results from the allegations of the Claimant itself, is linked to a non-concretization of the calculations it made regarding the value it would invoice to its Users in compliance with type A) contracts.

According to the Claimant, these income figures, now "reversed," were subject to accounting recognition and taxation in previous years.

It is to be inferred from the allegations of the Claimant that, since such income was considered and taxed in excess in previous years, in function of estimates that did not materialize, it would be appropriate to eliminate an equal amount in the 2012 fiscal year.[7]

The Respondent sustains in the RIT that "instead of having reduced income (by making a negative entry as credit to account 72) the company should have accounted for an expense in account 67 – Provisions for the period" and that "the amount accounted for with negative sign as credit in account 72 is nothing more than a provision for other charges".

This thesis of the Respondent could, in theory, and in the light of its argumentative line, only be defensible if the entries in question concerned increases in expenses, which is not the case. As is apodictic, the reduction in income, by making negative entries as credit from account 72 (regardless of the correctness of such entry), does not have the nature of an expense, resulting instead, in the disregard of income.

The thesis of the Respondent is not in conformity with the accounting standards noted, thereby violating, consequently, article 17, no. 1, of the Corporate Income Tax Code.

The tax act, in view of its substantiation, cannot be maintained in the legal order due to manifest error regarding the legal assumptions, such that the tax acts sub judice cannot but be annulled, with the result that knowledge of the defect in form concerning the substantiation of the assessment is rendered prejudicial.

-IV- Decision

Accordingly, the arbitral tribunal decides to declare the claim well-founded and to decree the annulment of the Additional Assessment of Corporate Income Tax (IRC), no. 2016... and Statement of Account Adjustment no. 2016..., relating to the tax year 2012, as well as the Decision Dismissing the Gracious Complaint submitted by the Claimant.

Value of the action: € 48,161.99 (forty-eight thousand, one hundred and sixty-one euros and ninety-nine cents).

pursuant to the provisions of article 306, no. 2, of the CPC and 97-A, no. 1, sub-paragraph a), of the CPPT and 3, no. 2, of the Regulation of Court Costs in Arbitration Proceedings.

Costs by the Respondent, in the amount of € 2,142.00 (two thousand one hundred and forty-two euros) pursuant to no. 4 of article 22 of the RJAT.

Notify.

Lisbon, CAAD, 26.11.2018

The Arbitrator

Marcolino Pisão Pedreiro

[1] See Chart of Accounts of the SYSTEM OF ACCOUNTING STANDARDIZATION ("SNC") (Order no. 1011/2009, D.R. no. 175, Series I, of 2009-09-09).

[2] See Notes on the Framework of the SNC Chart of Accounts.

[3] Ibid.

[4] Ibid.

[5] António Borges, Azevedo Rodrigues and Rogério Rodrigues, ELEMENTS OF GENERAL ACCOUNTING, 26th Edition, 2014, Áreas Publisher, page 595.

[6] António Borges, Azevedo Rodrigues and Rogério Rodrigues, op. cit. page 596.

[7] It does not appear from the tax inspection report what occurred with the respective accruals of expenses with CPE that, in principle, logically, could also have been recorded in excess by the Claimant, in function of the estimates that did not come to pass.