Process: 163/2018-T

Date: December 28, 2018

Tax Type: IRC

Source: Original CAAD Decision

Summary

This CAAD arbitral decision (Process 163/2018-T) addresses crucial IRC tax issues for real estate investment funds concerning capital gains calculation and deductible rental income expenses. The case involves Fund A... contesting €420,178.91 in additional IRC assessments for 2013. The primary dispute concerned three issues: (1) calculating capital gains on the sale of common areas that didn't exist as autonomous fractions at acquisition; (2) deductibility of elevator and HVAC replacement costs as maintenance expenses; and (3) whether conservation expenses exceeding rental income from a specific property are deductible. The Tax Authority argued that common areas without autonomous fraction status at acquisition couldn't have recognized acquisition values for capital gains purposes, that equipment replacements constituted improvements rather than maintenance, and that Article 22(6) of the Tax Benefits Statute limits maintenance expense deductions to rents received per property. The Fund countered that common areas were integrated into the original acquisition subject to IMT proportionally, that works were necessary to maintain the building's original condition and preserve tenant relationships, and that expense limitation violated the principle of taxing net rental income and contributory capacity. This decision clarifies critical distinctions between deductible conservation expenses versus capital improvements for real estate funds, addresses the proportional allocation of acquisition costs to subsequently individualized property components, and interprets statutory limits on maintenance expense deductibility against constitutional taxation principles.

Full Decision

ARBITRAL DECISION

They agree in arbitral tribunal

I – Report

  1. Open-ended Real Estate Investment Fund A..., with tax identification number..., with registered office in ..., ..., ..., ..., represented by management company B...– Real Estate Investment Fund Management, hereby requests the constitution of an arbitral tribunal, pursuant to the provisions of articles 2, no. 1, subparagraph a), and 10 of Decree-Law no. 10/2011, of 20 January, to assess the legality of the tax acts of additional Corporate Income Tax (IRC) assessment and compensatory interest assessment, in the total amount of € 420.178,91, relating to the 2013 fiscal year, and further requesting reimbursement of the tax improperly paid and condemnation to pay compensatory interest.

It bases the request on the following grounds.

In the disposal of common areas of the building located on ..., the Applicant calculated the capital gain due in the amount of € 207.741,09, corresponding to the difference between the realization value, in the amount of € 350.000,00, and the acquisition value (€ 128.000,00) plus expenses incurred (€ 4.963,13).

The Tax Authority came to disregard the amount calculated as capital gain on the grounds that only the value relevant for Municipal Property Transfer Tax (IMT) assessment could be considered as acquisition value and the common space did not exist as an autonomous fraction at the time of acquisition of the property and was outside the scope of taxation.

The Applicant argues that the referred space was integrated into the acquired property and was subject to IMT in proportion to the overall acquisition cost that corresponded to it, and the acquisition value should be calculated in accordance with the provisions of article 46, no. 1, of the Income Tax Code (IRS) in the stated amount of € 128.000,00.

In this sense, the additional assessment act suffers from violation of the cited provision of the IRS Code and calls into question the principle of contributory capacity.

The Tax Authority further disregarded the deduction of expenses associated with obtaining rental income from the property ... located on ..., on the grounds that such expenses resulting from the replacement of elevators and air conditioning, heating and ventilation equipment do not constitute expenses for maintenance and conservation of the building because it was not proven that they were essential for obtaining the rents.

However, those works were intended to maintain the building in the conditions existing at the date of its construction and were necessary to ensure maintenance of the rental contract with the insurance company Fidelidade, which was unwilling to renew the contract in view of the deficiencies the building presented.

The Tax Authority also disputes the deduction of expenses incurred with the building located in ... considering that the construction works carried out correspond to structural works and property refurbishment that do not fall within maintenance and conservation expenses.

The Applicant argues, however, that the building showed signs of deterioration and, intending to place the property on the rental market after the end of the existing contract, found it necessary to carry out conservation works in order to restore the level of habitability of the leased property, having for this purpose launched a "Design Competition - Construction for Project and Civil Construction Work, Finishes and Technical Installations for Remodelling".

The project included civil construction works, general roof covering review, replacement of window frames and fire doors, replacement of electrical installation and communications infrastructure, as well as replacement of elevators and air conditioning systems, and therefore, the intervention as provided for in the technical specifications did not imply the enlargement or relevant alteration of the building, but merely conservation works that did not result in the revaluation of the building for purposes of municipal property tax.

The Tax Authority further disregarded the amount of € 387.135,09 relating to expenses incurred by the Applicant on the grounds that, for purposes of determining taxable income regarding rental income, maintenance and conservation expenses are only deductible up to the limit of rents received.

This limitation on expense deduction is, however, contrary to the principle established in article 22, no. 6, of the Tax Benefits Statute, whereby taxation of rental income applies to net income after maintenance and conservation expenses effectively incurred, and violates the principle of contributory capacity.

The Tax Authority, in its reply, argues that the property located on ... Street constituted, at the date of acquisition, an indivisible asset and when horizontal property ownership was established the space denominated "office" became a common area of exclusive use of Fraction B (shop). The Applicant divided the property acquisition cost, in the total amount of € 1.600.000,00, between the residential part (from Fraction C to Fraction J), corresponding to € 700.000,00, and the part of shops and office (Fraction A and Fraction B), corresponding to € 900.000,00.

In calculating capital gains, the Tax Authority based itself on the value attributed by the Fund to the residential part and to the shop part and the proportion percentage of each fraction fixed in the horizontal property deed, having disregarded the acquisition value of the "office" insofar as it did not exist as an autonomous fraction at the date of acquisition of the property and was not transformed into an autonomous fraction in the horizontal property deeds subsequently executed.

As regards the corrections made to rental income, the Tax Authority considers that the tax-deductible expenses, under the terms of subparagraph a) of no. 6 of article 22 of the Tax Benefits Statute, are the maintenance and conservation expenses effectively incurred relating to properties or autonomous fractions of leased properties that do not exceed the rents received, with no transferability of expenses between properties, that is, the expenses of one property cannot be allocated to another property.

On the other hand, expenses incurred on either "Building..." or "Building..." cannot be accepted since these relate to interior remodelling or reconstruction of the properties and do not fall within the concept of maintenance and conservation expenses.

It concludes that the request is without merit.

  1. Following the proceedings, the meeting referred to in article 18 of the RJAT was dispensed with and the hearing of the Applicant's party requests was rejected.

In submissions within the successive deadline, the parties pronounced themselves on the probative results arising from the documents in the proceedings and, otherwise, maintained their previous positions.

  1. The request for constitution of the arbitral tribunal was accepted by the President of CAAD and automatically notified to the Tax Authority under the applicable regulations.

Pursuant to the provisions of subparagraph a) of no. 2 of article 6 and subparagraph b) of no. 1 of article 11 of the RJAT, in the wording introduced by article 228 of Law no. 66-B/2012, of 31 December, the Ethics Council designated the signatories as arbitrators of the collective arbitral tribunal, who communicated acceptance of the assignment within the applicable deadline.

The parties were duly and timely notified of this designation and did not manifest any intention to refuse it, under the combined terms of article 11, no. 1, subparagraphs a) and b), of the RJAT and articles 6 and 7 of the Ethics Code.

Thus, in accordance with what is provided in subparagraph c) of no. 1 of article 11 of the RJAT, in the wording introduced by article 228 of Law no. 66-B/2012, of 31 December, the collective arbitral tribunal was constituted on 14 June 2018.

The arbitral tribunal was duly constituted and is materially competent, in accordance with the provisions of articles 2, no. 1, subparagraph a), and 30, no. 1, of Decree-Law no. 10/2011, of 20 January.

The parties have legal capacity and standing, are legitimate and are duly represented (articles 4 and 10, no. 2, of the same decree-law and 1 of Ordinance no. 112-A/2011, of 22 March).

The proceedings do not suffer from nullities and no exceptions were raised.

It is appropriate to hear and decide.

II - Grounds

Facts

  1. The facts relevant to the decision of the case which may be deemed established are as follows:

  • The Applicant was subject to tax audit proceedings conducted by the Tax Audit Services of the Lisbon Finance Directorate, in compliance with Service Order no. OI2016..., for the 2013 fiscal year, with the objective, in particular, of audit control regarding IRC;

  • Notified of the draft report on 14 November 2017, the Applicant exercised the right to be heard on 29 November following;

  • As a result of this audit action, IRC in arrears was calculated, in the amount of € 420.178,91, corresponding to the calculation of capital gain from the disposal of a property and the deduction of expenses relating to rental income;

  • The Applicant is an open-ended real estate investment fund with private subscription, subject to the Legal Regime of Real Estate Investment Funds;

  • The Fund is managed and represented by the management company called B...- Real Estate Investment Fund Management S.A., and is considered an IRC taxpayer;

  • In the course of its activity, the Fund buys, sells and leases real estate assets;

  • By deed executed on 9 September 2008, the Applicant acquired the building located at no. ... of ..., in Lisbon, which constituted the urban property registration number ... of the parish of ..., for € 1.600.000,00, which had at that date a heritage value of € 819.850,00;

  • The acquisition benefited from the IMT exemption applicable to open-ended real estate investment funds;

  • The property was under full ownership regime and contained spaces intended for commerce/services and housing;

  • On 7 March 2013, the deed establishing horizontal property ownership of the property was executed, determining its partition into ten autonomous fractions as follows:

Fraction A - Shop - no. ... ..., proportion 91

Fraction B - Shop - no. ... ..., proportion 93

Fraction C - First Right - no. ... ..., proportion 63

Fraction D - First Left - no. ... ..., proportion 91

Fraction E - Second Right - no. ... ..., proportion 63

Fraction F - Second Left - no. ... ..., proportion 103

Fraction G - Third Right - no. ... ..., proportion 61

Fraction H - Third Left - no. ... ..., proportion 102

Fraction I - Fourth Right - no. ... ..., proportion 67

Fraction J - Fourth Left - no. ... ..., proportion 266.

  • By correction executed on 14 October 2013, the space denominated office, which by oversight had been included as an integral part of Fraction B, came to be registered as a common area of exclusive use of that fraction;

  • The Fund divided the property acquisition cost of € 1.600.000,00 into cost of the residential part, corresponding to Fractions C and J (€ 700.000,00), and cost of the services/shops part, corresponding to shops A and B (€ 900.000,00);

  • With regard to the non-residential part, the cost of € 900.000,00 was distributed by the taxpayer as follows: Shop A - € 225.000,00; Shop B - € 547.000,00; "Office" - € 128.000,00;

  • On 21 October 2013, the Applicant disposed of the "Office" to C..., S.A., for the total value of € 350.000,00;

  • The disposal of the "Office" was subject to IMT;

  • As a result of this disposal, the Applicant calculated a capital gain in the amount of € 207.741,09, corresponding to the difference between the realization value, in the amount of € 350.000,00, and the acquisition value (€ 128.000,00) plus expenses incurred for maintenance (€ 4.963,13);

  • The Tax Audit Report did not consider the declared acquisition cost of € 128.000,00 on the grounds that the acquisition value for valuable consideration of real estate assets is the value that served for purposes of assessing the municipal property transfer tax, and the space denominated as "office" was a common space of the property that was not registered as an autonomous fraction and fell outside the scope of IMT;

  • The Tax Authority, as a result of this correction, calculated a positive balance of capital gains and losses of € 47.920,65, implying an increase in the tax due in the amount of € 17.648,10;

  • In the 2013 fiscal year, the Applicant obtained rental income from the building ..., located on ... Street, in Lisbon, which it subjected to IRC taxation under the terms of article 22 of the TBS;

  • The Fund considered deductible, for purposes of determining taxable income relating to rental income from "Building...", expenses incurred for the replacement of elevators and air conditioning, heating and ventilation equipment, in the amount of € 425.816,08;

  • The tenant of the building stated, in correspondence maintained with the Applicant, that the continuation in the leased property was dependent on the review of the air conditioning system and remodelling of elevators since these works "impact the tenant's operability";

  • The Tax Audit Report did not accept the expenses relating to the works carried out in Building ... on the grounds that it was not proven that they were essential to obtaining the income nor essential to maintain the state of the property;

  • In the 2013 fiscal year, the Applicant obtained rental income from the building located in ..., in Lisbon, which it subjected to IRC taxation under the terms of article 22 of the TBS;

  • D... S.A. prepared, in 2004 and at the request of the General Directorate of Justice Administration, a Technical Maintenance Report relating to the property in question, stating that the false ceilings were in poor condition;

  • The property appraisal report, prepared by E..., notes that "although externally the building has a modern appearance, thanks to its architectural characteristics, internally it requires improvement and conservation works";

  • The Applicant obtained a budget, drawn up on 10 May 2012, for "Design Competition - Construction for Civil Construction Work Project, Finishes and Technical Installations for Remodelling of Building ..., no. ..., in Lisbon", attached as doc. 14, whose content is taken as reproduced;

  • The Applicant spent the amount of € 2.498.224,01 in carrying out these works;

  • The works carried out did not require municipal licensing, except for public right of way occupation and scaffolding installation;

  • The Tax Authority did not accept that amount as expenses for purposes of determining net income, considering them to be structural and property refurbishment works;

  • The Tax Authority determined the correction of expenses allocated to certain properties under the terms of the table contained in page 28 of the Tax Audit Report, in the amount of € 387.135,09, considering that expenses cannot exceed rents received and expense transferability between properties is not permitted.

  • Following the inspection, assessments relating to the 2013 fiscal year were issued, with IRC no. 2017... and compensatory interest no. 2017..., which were notified to the Applicant;

  • The Applicant made payment of the assessed tax on 30 January 2018.

The Tribunal formed its conviction regarding the proven facts based on the documents attached to the petition and on the administrative proceedings filed by the Tax Authority with its reply.

Law

The Applicant submits to the Arbitral Tribunal corrections made by the TA regarding IRC for the 2013 fiscal year, relating to the determination of rental income and capital gains regarding two properties of which it is the owner.

To respond to the issues raised, it is necessary to bear in mind, as preliminary points, on the one hand, the fact that the Applicant is an IRC taxpayer by virtue of the provision in subparagraph b) of no. 1 of article 2 of the IRC Code, but whose taxation at the time in question – 2013 - was subject to a particular regime provided for in article 22 of the Tax Benefits Statute.

With regard to the income in question, no. 6 of that article 22 provided, in the wording of Law no. 66-B/2012, of 31 December (which is relevant to the case):

  • "The income of real estate investment funds that are established and operate in accordance with national legislation has the following tax regime:

a) In the case of rental income, which does not relate to social housing subject to legal regimes of controlled costs, there is taxation, autonomously, at the rate of 25%, which applies to net income after maintenance and conservation expenses effectively incurred, duly documented, as well as municipal property tax (IMI) …".

b) In the case of real estate capital gains, which do not relate to social housing subject to legal regimes of controlled costs, there is taxation, autonomously, at the rate of 25%, which applies to 50% of the positive difference between capital gains and capital losses realized, calculated in accordance with the Income Tax Code …".

It is thus indisputable that the Applicant, as a Real Estate Investment Fund (FII), although without legal personality, was and is an IRC taxpayer and that, as such, is subject to the provisions of the IRC Code with the necessary adaptations, having in particular regard to the special taxation of some of its income, in light of what was provided in no. 6 of article 6 of the TBS.

In view of such particularity the Respondent argues that to FIIs the principle of period separation (article 18 of the IRC Code) is not applicable, but rather the so-called cash basis regime – in which financial movements are relevant – applicable to IRS taxpayers.

We understand, however, that without reason.

The Respondent supports this conclusion on the grounds that "the tax regime applicable to real estate investment funds follows the logic of the regime established for mobile investment funds which is inspired by the system outlined in the Income Tax Code for the taxation of capital income, mobile capital gains and, in part, rental income and other income". Despite making such considerations, the Respondent identifies previously and assertively the rules applicable to FIIs, considering that "they have organized accounting and prepare financial statements in compliance with the Chart of Accounts of Real Estate Investment Funds, approved by CMVM Regulation no. 2/2005".

Now, it so happens that the aforementioned Chart of Accounts of Real Estate Investment Funds – published in the Official Gazette, Series II, No. 96/2005, of 18 May – establishes in point 2.2 of Chapter 2, under the heading "Accounting principles and valuation criteria" that as an accounting principle the period separation principle is adopted, which it expresses in the following terms: "Period separation. The heritage elements of the fund must be valued and recognized in accordance with the periodicity of the calculation of the unit value of participation independently of their receipt or payment and must be included in the financial statements of the period to which they relate, as well as their adjustments in value arising therefrom".

This means that it is the Chart of Accounts itself (of mandatory application to all FIIs, as per point 1.2) that stipulates the mandatory application of the principle of period separation to FIIs. Which, as is obvious, must be of general application and not in a divided manner depending on the type of income or costs that are at issue.

All considerations that the Respondent makes in this regard and that, in any way, have relevance to the corrections carried out, are therefore without merit.

Having said that, it is necessary to determine the legality of the corrections made in the determination of capital gain and rental income obtained by the Applicant.

Let us examine this then.

CAPITAL GAIN

As results from the probative evidence, the Applicant acquired in 2008 a building not established under horizontal property ownership regime that comprised spaces intended for commerce and services and housing. The acquisition value of € 1.600.000,00 was then divided into € 700.000,00 for the residential part and € 900.000,00 for the intended services and shops part (with € 225.000,00 allocated to one shop, € 547.000,00 to another and € 128.000,00 to what it designated as "office").

Acquisition that, although subject to IMT, benefited from the exemption from that tax provided for in article 49 of the TBS.

In 2013 the referred property was established under horizontal property ownership regime.

It is not controversial for the parties that, when establishing horizontal property ownership and, in particular, for purposes of determining proportional shares, the Applicant proportionally divided the acquisition cost among the various fractions established and common areas.

Meanwhile, as a result of segregation of the property already established under horizontal property ownership, a parcel – originally designated as "office" – corresponding to a common part of the property was sold for the price of € 350.000,00.

As a result of this disposal, the TA disregarded the price that had been considered and allocated as the acquisition value of that parcel - € 128.000,00 -, considering that the acquisition value would be equal to zero "insofar as the office did not exist as an autonomous fraction at the time of acquisition of the property and the Fund also did not register it as an autonomous fraction in the two horizontal property deeds subsequent to acquisition".

We believe that without reason.

In accordance with the provisions of subparagraph c) of no. 6 of article 22 of the TBS, real estate capital gains obtained by FIIs would be calculated in accordance with the Income Tax Code. Now, subparagraph a) of no. 1 of article 10 of the IRS Code established that capital gains consist of gains resulting from the valuable disposal of real rights over real estate.

Without need for additional considerations, it is unequivocal that the parcel disposed of, although constituting a common part of the property, constitutes a real estate asset – being irrelevant whether it integrates an autonomous fraction or not - and that the property right transferred is a real right, thus meeting the objective conditions for taxation.

Being underlying the capital gain that concept of transmission, it is inherent to this that the right disposed of was previously acquired. Acquisition that can take place by gratuitous or valuable means, with no third way existing.

Hence, so that the capital gain can be determined, the IRS Code also provides for these two forms of acquisition so that, by comparison with the so-called realization value, the capital gain or loss can be calculated. In accordance with article 45 of that code, in the case where the asset was acquired for valuable consideration, the acquisition value is the one that served for purposes of assessing Municipal Property Transfer Tax or, similarly to what occurs with Stamp Tax, that which would serve as the basis for its assessment if it were due. For its part, article 46 establishes that being the acquisition of real estate effected for valuable consideration that value is the one that served for purposes of IMT assessment or, similar to what happens with Stamp Tax, the one that would serve as the basis for its assessment if it were due.

This means that in any circumstance there must always exist an acquisition value which is defined under the terms mentioned, and it is not understood how the TA can reach the conclusion that there is no acquisition value.

Such a conclusion would violate, in any case, in an ostensible manner the principle of contributory capacity, which has constitutional recognition.

In the case, the Applicant presents as acquisition value the € 128.000,00 that it declared for purposes of IMT.

It is a different matter if the TA does not agree with the values declared as acquisition and disposition, but for this it would have the proper mechanisms established in the respective taxation regimes (in article 52, no. 1 of the IRS Code or, for example, in article 31 of the IMT Code). The TA carried out no action at this level, having in fact conformed to the value declared in the acquisition for purposes of IMT assessment, despite the exemption from tax that the Applicant benefited from.

It cannot now and without any legal basis claim to subvert the rules for determining capital gain, disregarding the existence of acquisition value.

The Applicant's claim is therefore well-founded in this respect.

RENTAL INCOME

In the course of its activity, the Applicant obtained rental income which it subjected to taxation after deducting expenses that it qualified as maintenance and conservation expenses.

As income from two properties is at issue, the TA did not accept such expenses as deductible because, among other reasons, it understood that they relate not to maintenance and conservation expenses but to refurbishment of the properties in question.

The Respondent further understands, on the one hand, that for purposes of determining taxable income regarding rental income, only expenses incurred up to the limit of rents received, calculated individually for each property, should be considered. And that, on the other hand, transferability of expenses between properties is not to be permitted.

Beginning with this last point, we fail to see where the Respondent finds legal basis for the attempted correction.

In accordance with the understanding already expressed, the taxable income of FIIs, within some conditions that will be analyzed later, is determined, as IRC taxpayers that they are, under the terms of the rules of that respective code. Hence rental income should be considered as such income which under the accounting standards can be qualified as such, deducted from expenses which by their nature can be considered as such, without any other type of restriction.

To this does not stand in the way the fact that the costs accepted are higher than the income.

In fact, even if the rules of the IRS Code had to be applied, the solution would be the same, having in particular regard to the wording of no. 1 of article 41 of that code.

Moreover, the admissibility of the existence of a negative net result in the category of rental income in IRS and the possibility of its carryover in the following years has always been admitted by that code: at that date in the five following years and currently in the six following (article 55, no. 2 and currently in no. 1, b), respectively).

Let us now examine whether, taking into account the nature of the expenses at issue, their acceptance and deductibility to the Applicant's rental income should be accepted.

As already mentioned, article 22 of the TBS provided that rental income obtained by FIIs would be considered net of maintenance and conservation expenses effectively incurred, duly documented, as well as municipal property tax (IMI).

From the analysis of that provision it follows that for expenses incurred by FIIs connected with rental income to be considered as deductible, in addition to having to be "indispensable for the realization of income subject to tax or for the maintenance of the income-producing source", as no. 1 of article 23 of the IRC Code imposes across the board to all IRC taxpayers, they have a qualified requirement. Indeed, only those expenses are to be considered, apart from IMI incurred, that are considered to be maintenance and conservation of the properties in question.

Having said that, it is necessary to bear in mind that the so-called maintenance and conservation expenses are concepts of a civil law nature and as such must be considered, in compliance with the provision in no. 2 of article 11 of the LGT when it establishes that "whenever in tax rules terms proper to other branches of law are used, they must be interpreted in the same sense as they have there, unless otherwise directly provided by law".

Such concepts are considered precisely within the scope of the rental contract. Article no. 1 of article 1074 of the Civil Code states that "it falls to the landlord to execute all conservation works, ordinary or extraordinary, required by applicable laws or by the purpose of the contract, unless otherwise agreed", not defining them today as rigorously as did the repealed Urban Rental Regime. Article 11 of that diploma stated:

"1 - In urban properties, and for purposes of this diploma, there may be ordinary conservation works, extraordinary conservation works and improvement works.

2 - Ordinary conservation works are:

a) General repair and cleaning of the property and its dependencies;

b) Works imposed by the Public Administration, under applicable general or local law, aimed at giving the property the characteristics presented when the use license was granted;

c) In general, works intended to maintain the property in the conditions required by the purpose of the contract and existing at the date of its celebration.

3 - Extraordinary conservation works are those occasioned by defect of construction of the property or by act of God or force majeure, and, in general, those which, not being attributable to unlawful actions or omissions perpetrated by the landlord, exceed, in the year in which they become necessary, two-thirds of the net income of that same year.

4 - Improvement works are all those not covered by the two previous numbers".

The recourse to the cited article 11 of the RAU is, however, still today, in view of the lack of definition in current legislation of those concepts, used both by doctrine and by jurisprudence, for their concretization.

It is thus commonly accepted, both in doctrine and in jurisprudence, that ordinary conservation works are those "in general, intended to maintain the property in good condition of preservation and in the conditions required by the purpose of the contract and existing at the date of its celebration". By contrast, there will be "extraordinary conservation works occasioned by defect of construction of the property or by act of God or force majeure, that is, by unforeseeable or unavoidable event and, in general, those which, not being attributable to unlawful actions or omissions perpetrated by the landlord, exceed, in the year in which they become necessary, two-thirds of the net income of that same year" (Aragão Seia – Urban Rental, 6th ed., p. 196). By way of example, reference may be made, in jurisprudence, to the Decisions of the Porto Court of Appeal of 04-12-2000 – Proc. 0051266; of 19-10-1993 – Jurisprudence Collection XVIII, 4, p. 233, and of Lisbon of 13-01-1994 - Jurisprudence Collection XIX, 1, p. 91 and of 06-04-1995 – Jurisprudence Collection XX, 2, p. 111.

Let it be said, on the one hand, in view of what was mentioned, that the fact that works are not of a structural character is not, in itself, a determining element for the works to be considered as ordinary conservation.

And, on the other hand, that, with regard to the so-called "ordinary conservation works" the responsibility for their execution always falls on the landlord, whereas "extraordinary conservation works" as well as "improvement works", only remain the responsibility of the landlord when, under the terms of applicable administrative laws, their execution is ordered by the competent municipal authority or when there is written agreement of the parties to their execution, with a description of the works to be carried out (Decision of Porto Court of Appeal of 04-12-2000).

Such understanding has also been adopted in tax jurisprudence, namely by the STA when, in the decision of 06-07-2016 – Proc. no. 088/2016, it reads: "maintenance and conservation expenses will be expenses that are necessary for the maintenance and conservation of the properties that generate income. They may be, as previously defined in the Urban Rental Regime, article 11, expenses incurred with ordinary conservation works - general repair and cleaning of the property, works imposed by the Public Administration, and in general those intended to maintain the property in the conditions required by the purpose of the contract and existing at the date of its celebration; extraordinary conservation works – of repair of defects of construction of the property or supervening or improvement of the property, with repercussion on the property and its capacity to generate income". And, even more recently, also in the Decision of the South Administrative Court of Appeal of 15-12-2016 – Proc. 05310/12, where it states that extraordinary conservation works and improvement works only remain the responsibility of the landlord when administratively imposed or when there is written agreement of the parties with a description of the works to be carried out.

From the foregoing, we are forced to conclude that the concept of expenses for conservation and maintenance works to which refer both article 22, no. 6, a) of the TBS and article 41, no. 1 of the IRC Code, integrate the concept above described of "ordinary conservation works". They will, therefore, as a rule, fall outside its scope of application, both "extraordinary conservation works" and "improvement works", unless these have resulted from administrative imposition or express agreement.

Bearing these considerations in mind, let us begin by analyzing whether the expenses incurred by the Applicant with the replacement of elevators and air conditioning, heating and ventilation systems effected in "Building ..." will integrate the concept of "ordinary conservation works".

It is manifest that the works carried out, although in equipment installed in the building, integrate the concept of maintenance and conservation expenses. As was proven, the tenant itself manifested to the Applicant the unwillingness to maintain the rental contract or to renew it, should the deficiencies in those equipment remain.

That is, their replacement aimed at nothing more than to confer and restore the property to conditions of habitability and use identical to those existing at the date of conclusion of the contract. If those equipment, an integral part of the lease, did not already meet the satisfactory conditions for the purpose they were intended for, it is unquestionable that their replacement integrates the concept of maintenance and conservation expenses.

It is therefore illegal the correction made by the Respondent in this respect by considering their non-deductibility.

This will not be the case as regards the works carried out in the designated "Building...".

For such works, more than maintaining the property in the conditions necessary for maintenance of any rental, aimed at providing the building with other capacities and aptitudes more attractive for that purpose, having moreover resulted from a "Design Competition – Construction for Civil Construction Work Project, Finishes and Technical Installations for Refurbishment".

From the report of the company "D..." – attached as doc. 12 – no consequences can be drawn as it is impossible to establish any temporal connection with the works at issue, given that these were executed in 2013 and that one is from March 2004.

In the very report prepared by the company "E...", in June 2012 - attached as doc. 13 - it states, "… the office floors, currently vacant … although externally the building possesses a modern appearance, thanks to its architectural conditioning characteristics, internally it requires improvement and conservation works" (our emphasis), which the Applicant transcribes in point 111 of the initial petition. That is, the Applicant was aware and intended that the property would be subject to works with different levels of intervention.

Indeed, that report was intended to evaluate the property both in the sales market and in the rental market on the assumption that improvement works would be introduced into it. It states: "to the market value of the property free and available, after completion of works, the costs of rehabilitation and modernization of the property were deducted" (our emphasis).

It is sufficient to look at the budget that the Applicant attaches as doc. 14 to reach the same conclusion. Outstanding, by way of merely exemplary illustration:

"- demolition of brick partition walls in accordance with the desired alterations;

  • dismantling of wall coverings in wooden agglomerate boards, removal of ledges and furniture that do not fit the new project;

  • demolition of slabs and reinforced concrete elements necessary for the execution of the project … slabs for the execution of the new project;

  • widening of the access staircase to Fraction V in ...,

  • execution of brick masonry walls set with cement and sand mortar;

  • etc …"

It is not questioned that the expenses incurred by the Applicant are susceptible of increasing the value and useful life of the property and that, in the abstract, would be framed as a cost accepted within article 23 of the IRC Code. However, as already seen, in order for costs incurred by the FII, aimed at obtaining rental income, to be considered as deductible, they must, more than that, be qualified as maintenance and conservation expenses, which, as is seen, is not the case.

There is therefore nothing to be pointed out to the correction made by the TA which deserves no censure.

COMPENSATORY INTEREST

In addition to reimbursement of the tax, the Applicant requests that the right to payment of compensatory interest be declared.

This right is enshrined in article 43 of the LGT, which is premised on the determination, in administrative appeal or judicial challenge – or in tax arbitration – that there was error attributable to the services resulting in payment of the debt in an amount higher than legally due.

The recognition of the right to compensatory interest in the arbitral proceedings results from the provision in article 24, no. 5 of the RJAT, when it stipulates that "payment of interest, regardless of its nature, is due under the terms provided in the general tax law and in the Tax Procedure and Process Code".

In the case at hand, it is manifest that an error attributable to the TA indeed occurred in the assessment in question which it itself carried out without legal support.

Therefore the Applicant is entitled to the requested payment of compensatory interest regarding the portion of tax annulled, under the terms arising from what has been stated above.

III – Decision

They therefore decide as follows

  • To declare the arbitral request partially well-founded and, consequently, to declare the illegality of the IRC assessment no. 2017..., relating to the year 2013, and corresponding compensatory interest, which act shall be maintained only as regards the non-admissibility of the expenses considered by the Applicant relating to the property designated "Building...".

  • To condemn the Tax and Customs Authority to reimburse the Applicant the amount of the corresponding tax regarding the referred assessment, plus the respective compensatory interest.

  • To condemn both parties to the payment of costs of the proceedings, in the proportion of 72.34% by the Respondent and 27.66% by the Applicant.

Value of the proceedings

The value of the proceedings is fixed at 906.542,42 €, under the terms of article 97-A, no. 1, a), of the Tax Procedure and Process Code, applicable by virtue of subparagraphs a) and b) of no. 1 of article 29 of the Legal Regime of Tax Arbitration and no. 2 of article 3 of the Regulation of Costs in Tax Arbitration Proceedings.

Costs

The amount of the arbitration fee is fixed at 12.852,00 €, under the terms of Table I of the Regulation of Costs of Tax Arbitration Proceedings, under the terms of articles 12, no. 2, and 22, no. 4, both of the Legal Regime of Tax Arbitration, and article 4, no. 4, of the aforementioned Regulation.

Let it be notified.

Lisbon, 28 December 2018.

The President of the Arbitral Tribunal

Carlos Fernandes Cadilha

The Arbitrator Member

Leonor Fernandes Ferreira

The Arbitrator Member

António Alberto Franco

Frequently Asked Questions

Automatically Created

How are capital gains calculated for real estate investment funds under Portuguese IRC rules?
Under Portuguese IRC rules for real estate investment funds, capital gains are calculated as the difference between the realization value and the acquisition value plus associated expenses. The acquisition value must be determined according to Article 46(1) of the IRS Code. A critical issue arises when common areas are sold that didn't exist as autonomous fractions at the original property acquisition. The Tax Authority's position is that only values relevant for IMT assessment at acquisition can be considered, potentially disallowing acquisition values for spaces that lacked autonomous fraction status. However, funds argue that if common areas were integrated into the acquired property and subject to IMT proportionally based on overall acquisition cost, their proportional acquisition value should be recognized for capital gains calculations. This involves allocating the total property acquisition cost among different components based on reasonable criteria, even when horizontal property divisions occur post-acquisition.
Can the acquisition value of common areas be considered when calculating capital gains on property sales?
The deductibility of conservation and maintenance expenses from rental income under Portuguese IRC law is governed by Article 22(6) of the Tax Benefits Statute (EBF). This provision allows deduction of maintenance and conservation expenses effectively incurred relating to leased properties or autonomous fractions. However, significant restrictions apply: (1) expenses cannot exceed rents received from the specific property, with no transferability between properties; (2) expenses must constitute genuine maintenance/conservation rather than improvements, remodeling, or structural alterations; (3) works must be essential for obtaining rents or maintaining existing rental conditions. The Tax Authority interprets these limitations strictly, applying a property-by-property matching requirement that prevents aggregating expenses and income across a fund's portfolio. Taxpayers argue this interpretation violates the principle of taxing net income and contributory capacity, particularly when conservation works are necessary but temporarily exceed a single property's rental income.
What types of conservation and maintenance expenses are deductible from rental income for IRC purposes?
Portuguese tax law distinguishes between deductible conservation/maintenance expenses and non-deductible capital improvements or structural alterations. Elevator replacements and HVAC system installations present difficult classification issues. The Tax Authority typically considers complete equipment replacement as improvement expenditure rather than maintenance, particularly when not proven essential for obtaining rents. However, taxpayers successfully argue deductibility when demonstrating: (1) works maintain the building in its original constructed condition rather than enhancing it; (2) replacements are necessary to preserve existing tenant relationships or rental contracts; (3) interventions don't result in property revaluation for municipal property tax purposes; (4) works restore habitability or functionality rather than expanding or significantly altering the building. Technical specifications and project documentation proving the conservation nature of works become critical evidence. CAAD examinations focus on whether interventions merely restore versus improve property conditions, considering factors like tenant requirements, building deterioration, and whether works maintain versus enhance the property's rental value or structural characteristics.