IRS Capital Gains on Pharmacy Transfer (Trespasse): CAAD Arbitration 215/2015-T

ARBITRAL DECISION

The arbitrators Fernanda Maçãs (presiding arbitrator), Hélder Faustino and Armindo Fernandes Costa (arbitrators), appointed by the Deontological Council of CAAD to form the Arbitral Tribunal, constituted on 01-06-2015, agree as follows:

I. REPORT

1. The Applicants A… and B…, married, taxpayers no. … and no. …, respectively, with tax domicile at Avenue …, …, …, in Lisbon, having been notified of the supplementary assessment act for Personal Income Tax ("IRS") no. 2014 …, in the amount of € 314,465.29, of the compensatory interest assessment act no. 2014 …, in the amount of € 18,027.74 (amount included in the tax assessment) and of the account reconciliation statement no. 2014 …, from which resulted tax and compensatory interest payable in the total amount of € 140,102.84, came to file, under the provisions of subparagraph a), of section 1 of article 2 and subparagraph a) of section 1 of article 10 of Decree-Law no. 10/2011, of 20 January ("Legal Framework for Tax Arbitration", hereinafter "RJAT") a request for arbitral pronouncement with a view to the annulment of those acts.

2. The respondent is the Tax and Customs Authority (AT).

3. The claim object of the request for arbitral pronouncement consists of the annulment of those acts, together with the condemnation of the Tax and Customs Authority (AT) to pay the respective compensatory interest.

3.1. The Applicants petition:

a) the declaration of illegality of the IRS assessments and compensatory interest identified in 1. by violation of section 1 of article 5 of Decree-Law no. 442-A/88, of 30 November;

b) the declaration of illegality of the classification of capital gains arising from the transfer as income of Category B of IRS, by violation of the principles of legal certainty and protection of legitimate expectations;

c) subsidiarily, the declaration of illegality of the compensatory interest assessment, by failure to observe the right to prior hearing; and

d) further subsidiarily, the declaration of illegality of the compensatory interest assessment, by lack of substantiation;

e) the condemnation of AT to reimburse the tax unduly paid; and

f) the condemnation of AT to pay compensatory interest.

1. The request for constitution of the Arbitral Tribunal was accepted by the President of CAAD and automatically notified to AT.

4.1. The Applicants did not appoint an arbitrator, therefore, under the provisions of subparagraph a) of section 2 of article 6 and subparagraph b) of section 1 of article 11 of the RJAT, the President of the Deontological Council appointed the undersigned as arbitrators of the collective Arbitral Tribunal, who communicated acceptance of the appointment within the prescribed period.

4.2. On 15-05-2015, the parties were notified of the appointment of arbitrators and raised no objection.

4.2. In accordance with the provisions of subparagraph c) of section 1 of article 11 of the RJAT, the collective Arbitral Tribunal was constituted on 01-06-2015.

4.3. In these terms, the Arbitral Tribunal is regularly constituted to hear and decide the subject matter of the proceedings.

1. To support the request for arbitral pronouncement, the Applicants allege, in summary, the following:

a) Article 5/1 of Decree-Law no. 442-A/88, of 30 November, establishes that gains which were not subject to Capital Gains Tax only become subject to IRS if the acquisition occurred after the entry into force of the IRS Code ("CIRS"), namely on 1989-01-01;

b) The "Pharmacy …" was acquired by the 2nd Applicant in 1961;

c) Article 3/1 of the Capital Gains Tax Code provides that this tax applies to gains made from transfers of premises occupied by offices or professional practices engaged in the professions listed in the table attached to the Professional Income Tax Code;

d) The pharmaceutical activity of the 2nd Applicant was not listed in the table attached to the Professional Income Tax Code; and

e) Consequently, gains derived from the transfer of the "Pharmacy …" were not subject to Capital Gains Tax and, therefore, to IRS;

f) Furthermore, under article 10/1-d) of the CIRS, income from the onerous transfer of leases and other rights and assets permanently affected to the exercise of independent professional activities were considered income of Category G of IRS (Capital Gains), including the permanent allocation of such assets to purposes unrelated to the activity carried out;

g) Only with Law no. 30-G/00, of 29 December, did income from the onerous transfer of leases and other rights and assets permanently affected to the exercise of independent professional activities cease to be classified under Category G of IRS to be classified under Category B (Income from Independent Work);

h) Law no. 30-G/00, of 29 December, established a transitional rule whereby the amendments to article 10 of the CIRS would only apply to shareholdings and securities acquired after 2001-01-01, which suggests that the tax legislature intended to protect the legitimate expectations of taxpayers regarding situations that prevailed until the amendments effected by that legal instrument;

i) By acquiring the "Pharmacy …" in 1961, the 2nd Applicant conformed to the legislation then in force which excluded from taxation future income resulting from the transfer of the pharmaceutical establishment;

j) In this manner, the new classification of capital gains effected through Law no. 30-G/00, of 29 December, violates the principle of protection of legitimate expectations and, as such, should be excluded from taxation pursuant to article 5/1 of Decree-Law no. 442-A/88, of 30 November.

1. AT filed a response and attached the administrative file, alleging in summary the following:

a) "(…) until the entry into force of the CIRS the activity carried out by the 2nd Applicant was subject to Industrial Tax and not to Professional Income Tax.";

b) With regard to the issue of "(…) transfer of the pharmaceutical establishment, this fact was not subject to Industrial Tax (see article 25 of the Industrial Tax Code), but rather was subject to Capital Gains Tax." [emphasis in original];

c) The legislative option adopted "(…) was based on the fact that the transfer was an element of fixed assets [article 1, point 2, and article 3, § 1, subparagraphs a) and e) of the Capital Gains Tax Code]" [emphasis in original];

d) It is demonstrated that "(…) the incorrect understanding conveyed by the Applicants that the transfer was not subject to Capital Gains Tax (insofar as this only applied to gains made from transfers of premises occupied by offices or professional practices engaged in the professions listed in the table attached to the Professional Income Tax Code)." is wrong;

e) Thus, "(…) it must be concluded that the supplementary IRS assessment now challenged by the Applicants does not suffer from any illegality.";

f) On the other hand, "(…) the concept of transfer does not fit within the provision of the transitional legal rule invoked (i.e., article 3/5 of Law 30-G/00), since the latter refers clearly and unequivocally to "shareholdings" and to "other securities";

g) In fact, "(…) the legislation in force in 1961 did not exclude from taxation gains resulting from the transfer of the pharmaceutical establishment [see article 1, point 2, and article 3, § 1, subparagraphs a) and e) of the Capital Gains Tax Code and its preamble]";

h) "On the contrary, that fact WAS ALWAYS subject to taxation [see article 1, point 2, and article 3, § 1, subparagraphs a) and e) of the Capital Gains Tax Code and its preamble, article 4/2-d) of the original CIRS and article 3/1 of the CIRS in the version of Law 30-G/00]";

i) "The Applicants were given the opportunity to participate through notification to exercise the right to prior hearing upon notification of the tax inspection report draft" [emphasis in original];

j) "However, the Applicants chose not to make any remarks therein regarding the matter of compensatory interest";

k) AT further contends that "(…) the notification of compensatory interest in question was made and duly substantiated in accordance with the law, clarifying the taxpayer of the factual and legal reasons that determined the assessment.";

l) Finally, AT concludes, regarding the possibility of filing a response to the request for arbitral pronouncement, that "(…) the legislature's objective was not merely to allow the Respondent to improve the literary or narrative style contained in the said report, but rather merely to reinforce the base arguments contained in the substantiation, as in this case occurred".

1. As no exceptions were raised nor was evidence production requested, it was decided to dispense with the meeting provided for in article 18 of the RJAT, with 30 October being set as the deadline for the rendering of the arbitral decision.

2. It was further decided that the proceedings continue with successive written submissions.

3. The Applicants and the Respondent filed written submissions, maintaining, in essence, what was stated in the pleadings.

II. SANITATION

10.1. The parties have legal personality and capacity, are shown to be entitled and are regularly represented (articles 4 and section 2 of article 10 of the RJAT and article 1 of Ordinance no. 112-A/2011, of 22 March).

10.2. The tribunal is competent and regularly constituted.

10.3. The proceedings do not suffer from any nullities.

10.4. No exceptions were raised.

10.5. There are no other circumstances that prevent the merit of the case from being heard.

III. MERITS

III.1. Factual Matter

1. Proven Facts

11.1. With relevance for the appreciation and decision of the questions raised, the following facts are considered to be established and proven:

a) In the exercise of her professional activity, Applicant B… operated the "Pharmacy …", as a sole proprietor, under the organized accounting regime, and was classified under the activity of "Retail Trade in Pharmaceutical Products";

b) Applicant B… held the license for the "Pharmacy …" since 1961;

c) On 16-07-2009, Applicant B… established the company "C… – …, S.A." with share capital of 50,000 euros, represented by 50,000 shares with a nominal value of 1 euro each, with the following shareholding structure:

i. B… – 49,996 shares, valued at 49,966 euros, representing 99.992% of the share capital;

ii. A… – 1 share, valued at 1 euro, representing 0.002% of the share capital;

iii. D… – 1 share, valued at 1 euro, representing 0.002% of the share capital;

iv. E… – 1 share, valued at 1 euro, representing 0.002% of the share capital;

v. F… – 1 share, valued at 1 euro, representing 0.002% of the share capital.

d) On 02-11-2009, Applicant B… transferred, by public deed, the operation of the "Pharmacy …" establishment to the company "C… – …, S.A." for an annual value of 48,000 euros;

e) In turn, on 02-11-2009, the company "C… – …, S.A." entered into a sub-transfer agreement for the operation of the commercial establishment of the "Pharmacy …" with the company "G… Unipessoal, Lda.", in the capacity of prospective purchaser, for the value of 6,000 euros;

f) On 09-12-2010, Applicant B… entered into a transfer agreement for the "Pharmacy …" establishment, its corresponding fixed assets and inventories, for the value of 326,000 euros;

g) On 02-04-2014, a tax inspection action commenced pursuant to Service Order no. OI2014…, for IRS and VAT purposes, relating to the 2010 tax year;

h) Subsequently, through Official Communication no. …, of 20-10-2014, from AT, the Applicants were notified of the tax inspection report draft, which resulted in the following corrections:

i) The Applicants exercised their right to prior hearing, having only contested the correction relating to the capital gain resulting from the transfer of the "Pharmacy …" to the company "C… – …, S.A.";

j) Through Official Communication no. …, of 17-11-2014, from AT, the Applicants were notified of the final tax inspection report, which, however, maintained the proposed correction;

k) On 01-12-2014, the Applicants were notified of the supplementary IRS assessment act no. 2014 …, of the corresponding compensatory interest no. 2014 … and of the account reconciliation statement no. 2014 … in the total amount of € 140,102.84;

l) On 26-03-2015, the Applicants filed the request for arbitral pronouncement that gave rise to the present proceedings.

11.2. Substantiation of Factual Matter

The proven facts were based on documents attached to the request for arbitral pronouncement and in the administrative file, with no controversy regarding them.

11.3. There are no other facts relevant to the appreciation of the merits of the case that have not been proven.

III.2. Legal Matter

The central question to be decided centers on whether income resulting from the transfer of the "Pharmacy …" is, or is not, subject to IRS, as follows:

A) Concerning the illegality of the IRS assessment acts and compensatory interest by violation of section 1 of article 5 of Decree-Law no. 442-A/88, of 30 November[1].

First and foremost, it is important to clarify that the Applicants make an incorrect interpretation and application of the normative framework applicable to the case at hand, because they confuse the activity carried out as a liberal profession by a pharmacist with the activity of operating a pharmacy, which is a commercial activity.

Until the entry into force of the IRS Code[2], the activity carried out by Applicant B… (operation of a pharmacy) was subject to Industrial Tax.

Now, in accordance with article 1, sole paragraph of the Industrial Tax Code[3], "Industrial tax applies to profits attributable, under the terms of this code, to the exercise, albeit accidental, of any activity of a commercial or industrial nature. (…) The exercise, on one's own account, of activities not subject to professional income tax is always considered to be of a commercial or industrial nature (…)" [emphasis in original].

Already article 2 c) of the Professional Income Tax Code[4] established that "The income mentioned in the previous article is subject to tax when earned by natural persons, nationals or foreigners, who on the continent or adjacent islands: (…) c) Exercise on their own account some of the activities listed in the attached table." [emphasis in original].

That is, a contrario sensu, activities subject to Professional Income Tax exercised on their own account did not assume a commercial nature, which is not the case here, inasmuch as pharmaceutical activity was not included in the list of activities in the table attached to the Professional Income Tax Code.

Thus, the activity carried out by Applicant B… was subject to Industrial Tax and not to Professional Income Tax.

As for the transfer[5] of a commercial establishment, it was not subject to Industrial Tax[6], but rather to Capital Gains Tax[7] because it was the transfer of an element of fixed assets.

Indeed, in accordance with article 1, point 3 of the Capital Gains Tax Code, "Capital gains tax applies to gains realized through the acts listed below: (…) Onerous transfer, by whatever title, of elements of fixed assets and of goods or values maintained as reserves or for enjoyment by companies, including those not subject to industrial tax or agricultural industry tax or exempt from such taxes." [emphasis in original].

To reinforce this idea, note also the preamble of the Capital Gains Tax Code itself, according to which, "The idea that was taken as a basis for drawing the limits of the tax was to consider capital gains as the value increases of assets that taxpayers neither produced nor acquired for resale. It is an idea certainly subject to criticism from a theoretical point of view, but which has the advantage of being able to be used in practice. However, it was decided to apply it, not to all assets under those conditions, but only to assets whose capital gains occur more frequently, are of greater significance, or do not present serious difficulties in determination. This is what happens, without doubt, with building land; with elements of fixed assets of companies (among them transfers and licenses) and income-producing assets; with the right to lease offices and professional practices; with shareholdings in companies and shares. Precisely under the scope of the tax fall the capital gains of these four groups of assets." [emphasis in original].

It is also added by Saldanha Sanches[8] that, "Another particularly pronounced type of capital gain is that which results from commercial activity and which translates not only into present gains, but into an expectation endowed with a reasonable degree of probability regarding future gains. This is the case of goodwill or "value of the trade" of the commercial establishment as a complex of the merchant's or a company's commercial organization, in the form of an increase in its potential value, which can be realized through its disposal. This increase in value, substantially with the essential characteristics of capital gain, is in principle the normal result of commercial activity. The total value of an enterprise is normally above the value of the assets shown on the balance sheet at a particular moment in time, since it embodies an expectation regarding future revenues that depend on the name of the enterprise, its clientele, its organization, or the technologies it has. And from its activity result thus opportunities for future profit or control over certain assets susceptible to sustained value increase. And if this situation is capable of ensuring in the future a reasonable degree of probability, permanent and stable income flows, it can provide in the present, through the sale of the productive source, an immediate gain, this gain corresponding to the concept of capital gain. What has traditionally been reflected in Portuguese tax law in the traditional taxation of the transfer as an operation apt to produce a capital gain, although here it must be distinguished between the specific potentialities of the enterprise and the possibility of the existence of location rent, such as those linked to current rental legislation." [emphasis in original].

The author concludes that "The current position is to tax gains resulting from the transfer as a commercial and industrial capital gain. It is a balanced solution regarding its results, when it allows the deduction of acquisition costs." [emphasis in original].

For all the foregoing, it is clear that, contrary to what is argued by the Applicants, gains resulting from the transfer of Applicant B…'s pharmaceutical establishment were indeed subject to Capital Gains Tax, therefore the supplementary assessment under analysis does not violate the aforementioned section 1 of article 5 of the IRS Code.

B) Concerning the violation of the principles of legal certainty and protection of legitimate expectations

Also in this matter the Applicants make an incorrect interpretation and application of the normative framework applicable to the case at hand.

In fact, although the Applicants invoke, but without specifying, a transitional rule enshrined in Law no. 30-G/2000, of 29 December, "(…) whereby the amendments to article 10 of the CIRS would only apply to shareholdings and securities acquired after 2011-01-01, which suggests that the tax legislature intended to protect the legitimate expectations of taxpayers regarding situations that prevailed until the amendments effected by that legal instrument.", the referred rule applies only to shareholdings and other securities, making no reference whatsoever to the concept of transfer.

Now, if the tax legislature had intended to protect the legitimate expectations of taxpayers regarding transfers, it could have done so by enshrining such a purpose expressly and unequivocally in the letter of the law.

Having failed to do so, the Applicants certainly cannot read in the said transitional rule something that finds no minimum legal support in the letter of the law.

On the other hand, and as demonstrated previously, gains resulting from the transfer of Applicant B…'s pharmaceutical establishment were indeed subject to Capital Gains Tax, therefore it is not legitimate to conclude that the new classification of capital gains effected by Law no. 30-G/2000, of 29 December, violates the principle of protection of legitimate expectations.

In fact, already in the initial version of the IRS Code[9], the income in question was taxed as income of Category C[10], and remained so even after the publication of Law no. 30-G/2000, of 29 December, reclassifying that income to the new Category B[11].

Now, not only did the reclassification effected by the legislature not result in taxing a fact that was previously not subject to taxation, but the tax treatment given to capital gains was also not altered, maintaining their computation in accordance with the rules provided in the Corporate Income Tax Code ("IRC").

For all the foregoing, the tax act for the IRS assessment under analysis does not violate the principles of legal certainty and protection of legitimate expectations.

As the request for annulment of the IRS assessment no. 2014… and respective compensatory interest is not granted, the other requests consequently and necessarily fail, whereby the entire action is judged to be not granted.

IV. DECISION

Therefore, this Arbitral Tribunal agrees to judge the present action in its entirety to be not granted and, consequently, maintain the tax acts for IRS assessment no. 2014 … and respective compensatory interest, absolving the Tax and Customs Administration of all requests made against it.

V. VALUE OF THE PROCEEDINGS

In accordance with the provisions of section 2 of article 306 and section 2 of article 297, both of the Civil Procedure Code, subparagraph a) of section 1 of article 97-A of the Tax Procedure and Process Code and section 2 of article 3 of the Regulations on Costs in Tax Arbitration Proceedings, the value of the proceedings is set at € 140,102.84 (one hundred and forty thousand, one hundred and two euros and eighty-four cents).

VI. COSTS

In accordance with the provisions of section 4 of article 22, section 2 of article 12, both of the RJAT, article 2, section 1 of article 3, and sections 1 to 4 of article 4 of the Regulations on Costs in Tax Arbitration Proceedings, as well as in Table I attached to this legal instrument, the overall value of costs is set at € 3,060.00 (three thousand and sixty euros), to be borne by the Applicants.

Lisbon, 26 October 2015.

The arbitrators,

Fernanda Maçãs
(Presiding Arbitrator)

Hélder Faustino (Rapporteur)
(Arbitrator)

Armindo Fernandes Costa
(Arbitrator)

Text prepared by computer, in accordance with the provisions of section 5 of article 131 of the Civil Procedure Code, applicable by reference of subparagraph e) of section 1 of article 29 of the RJAT.

The text of this decision is governed by the orthography prior to the 1990 Orthographic Agreement.

[1] In accordance with the transitional regime established, "Gains which were not subject to capital gains tax, created by the code approved by Decree-Law no. 46673, of 9 June 1965, as well as those derived from the onerous transfer of rural properties affected by the exercise of an agricultural activity or the allocation of these to a commercial or industrial activity, exercised by the respective owner, only become subject to IRS if the acquisition of the assets or rights to which they relate was made after the entry into force of this Code." [emphasis in original].

[2] By force of the provisions of article 2 of Decree-Law no. 442-A/88, of 30 November, which approved the IRS Code, this legal instrument entered into force on 1 January 1989.

[3] Approved by Decree-Law no. 45.103, of 1 July 1963.

[4] Approved by Decree-Law no. 44.305, of 27 April 1962.

[5] On the concept of transfer, Saldanha Sanches clarifies that, "It can thus be concluded that transfer, as a legal transaction, is defined as the transmission of an establishment, understood as a set of assets and rights organized for the practice of commerce or industry. In cases where those rights include the right to lease, this should naturally be included in the object of the transmission, so that one can speak of a transfer. In other cases, the transfer does not depend on the existence or, consequently, on the transmission of that right." J. L. Saldanha Sanches / Manuel Anselmo Torres, "The Incidence of Stamp Tax on the Transfer of Commercial Establishments", Fiscalidade 32 (2008), p. 8.

[6] By force of the provisions of article 25 of the Industrial Tax Code.

[7] Approved by Decree-Law no. 46.373, of 9 June 1965.

[8] J. L. Saldanha Sanches, "Further on the Concept of Capital Gains", Fisco, 65-66 (1994), p. 8.

[9] Approved by Decree-Law no. 442-A/88, of 30 November.

[10] See subparagraph d) of section 2 of article 4 of the IRS Code.

[11] See section 1 of article 3 of Law no. 30-G/2000, of 29 December.