Deductibility of Business Costs Under Article 23 CIRC – IRC Arbitration Decision 234/2016-T

ARBITRAL DECISION

I – REPORT

A…, LDA., with the Tax Identification Number … and headquarters in …, …, requested the constitution of an arbitral tribunal, with a view to the declaration of illegality and consequent annulment of the additional assessments for Corporate Income Tax (IRC) which it named and will be identified below.

As there was no statement regarding the possible intention to designate an arbitrator, the undersigned arbitrators were appointed by the Deontological Council, an appointment which they accepted and which met with no opposition from any of the parties, with the tribunal being constituted on 1 July 2016.

The Tax Administration (AT) responded, within the legal timeframe, defending itself through contestation and attaching a copy of the administrative file.

On 2-11-2016, the hearing took place referred to in article 18 of the RJAT (Legal Framework for Tax Arbitration), with the examination of witnesses and statements by the party.

The date of 2 January was set for the delivery of the final decision.

The parties presented written submissions, pronouncing themselves on the evidence produced, reiterating and developing their respective legal positions.

II – PRELIMINARY EXAMINATION

The tribunal is competent, the parties are legitimate, endowed with legal personality and capacity, and are duly represented. There are no nullities, exceptions or preliminary matters that prevent the tribunal from hearing the claim.

III – MATTER OF FACT

1. FACTS ESTABLISHED

a) The Claimant is a limited liability company whose corporate purpose is the production and commercialization of electricity through the exploitation of renewable energy projects (as shown in the permanent certificate – access code …-…-…).

b) In 2006, the Claimant joined a consortium to participate in a bidding process for the acquisition, recovery and subsequent exploitation of mini-hydroelectric plants located in Romania.

c) On 20.11.2006, as a result of this bidding process, the consortium of which the Claimant was part acquired, for recovery and exploitation, 5 mini-hydroelectric plants all located in …, in …, Romania.

d) Following the acquisition, the Claimant and its consortium partners verified that the assets acquired and mentioned above did not match the descriptions contained in the bidding documents.

e) As a consequence of this verification, a court proceeding was initiated in Romania, in which the Claimant was a defendant, thus being obligated to contract the legal services of a law firm –B…– to represent it.

f) The Claimant paid for the legal services rendered through the following invoices which are recorded in its accounting:

• Invoice no. …2012…, in the amount of € 2,043.78 issued on 26-04-2012 by company B… and respective covering letter (document no. 13 attached with the arbitration request);

• Invoice no. …2012…, in the amount of € 3,689.48 issued on 29-06-2012 by company B… (document no. 14 attached with the arbitration request);

• Invoice no. …2012…, in the amount of € 8,770.00 issued on 14-09-2012 by company B… and respective covering letter (document no. 15 attached with the arbitration request);

• Invoice no. …2012…, in the amount of € 6,686.81 (document no. 16);

• Invoice no. …2012…, in the amount of € 3,442.39 issued on 31-10-2012 by company B… and respective covering letter (document no. 17 attached with the arbitration request);

• Invoice no. …2012…, in the amount of € 1,337.49 issued on 21-12-2012 by company B… and respective covering letter (document no. 18 attached with the arbitration request);

• Invoice no. …2013…, in the amount of € 2,826.85 issued on 30-01-2013 by company B… (document no. 19 attached with the arbitration request);

• Invoice no. …2013…, in the amount of € 671.43 issued on 24-07-2013 by company B… and respective covering letter (document no. 20 attached with the arbitration request);

• Invoice no. …2013…, in the amount of € 2,364.20 issued on 29-03-2013 by company B… and respective covering letter (document no. 21 attached with the arbitration request);

• Invoice no. …2013…, in the amount of € 1,143.32 issued on 29-04-2013 by company B… and respective covering letter (document no. 22 attached with the arbitration request);

• Invoice no. …2013…, in the amount of € 1,146.61 issued on 28-06-2013 by company B… and respective covering letter (document no. 23 attached with the arbitration request);

• Invoice no. …2013…, in the amount of € 1,242.48 issued on 31-10-2013 by company B… and respective covering letter (document no. 24 attached with the arbitration request).

g) Consequently, the Claimant recorded as costs relating to the services rendered by company B…, in the year 2012, the amount of € 28,796.80, and in the year 2013, the amount of € 6,568.04.

h) In the accounting records of the Claimant requested by the AT, the aforementioned Invoices were found; the Claimant made available to the AT all documents requested in the context of the tax audit procedure and also made itself available to present any additional document or information.

i) The AT did not request any other document, translation of documents or additional information.

j) The Claimant operates the Wind Park …, located in …, where two wind turbines for electricity production, its own property, are installed.

k) In the years 2012 and 2013, the Claimant used, with respect to the wind turbines of its wind farm, a depreciation rate of 8.33% corresponding to a useful life period of 12 years.

l) The useful life of these wind turbines is estimated to be between 10 to 20 years, taking into account technological factors, external factors, namely location, climatic conditions and winds, among others, economic factors, legal factors and the potential or expected use in regular conditions and also the contractual and technical conditions of connection to the national electricity grid.

m) In compliance with Service Orders OI2015… and OI2015… a tax audit procedure was initiated and carried out with respect to the fiscal years 2012 and 2013.

n) Through the Tax Audit Report - RIT (document no. 3 attached with the arbitration request and with the administrative file), the AT made the following adjustments to the taxable profit of the Claimant:

o) Following the aforementioned adjustments, the taxable base of the Claimant was adjusted from € 118,550.98 to € 261,146.20, relating to the fiscal year 2012, and from € 318,659.77 to € 439,347.57 relating to the year 2013, with the additional assessments in dispute here being issued (documents 1 and 2 attached with the arbitration request).

p) The Claimant voluntarily paid within the timeframe, on 10-03-2016, the contested IRC assessments (documents no. 29 and 30 attached on 26-04-2016).

q) The request for constitution of an Arbitral Tribunal was submitted on 20-04-2016.

1. JUSTIFICATION OF THE FACTS

Regarding the facts, the Tribunal does not have to pronounce itself on everything alleged by the parties; rather, it has the duty to select the facts relevant to the decision and to distinguish the established facts from those not established [cf. article 123(2) of the Code of Tax Procedure and Process (CPPT) and article 607(3) of the Code of Civil Procedure (CPC), applicable by virtue of article 29(1), paragraphs a) and e), of the Legal Framework for Tax Arbitration (RJAT)].

In this manner, the relevant facts for the judgment of the case are chosen and delineated in function of their legal relevance, which is established in consideration of the various plausible solutions to the question(s) of Law (cf. former article 511(1) of the CPC, corresponding to the current article 596, applicable by virtue of article 29(1), paragraph e), of the RJAT).

Thus, taking into consideration the positions assumed by the parties, in light of article 110(7) of the CPPT, the documentary evidence, the administrative file attached to the case, the statements made by the legal representative of the Claimant, C…, and the testimony of the witnesses it called, D…, E… and F…, the facts listed above were deemed established, with relevance for the decision, also taking into account that, as was written in the Decision of the TCA-South of 26-06-2014, in case 07148/131, "the probative value of the tax audit report (...) may have probative force if the assertions therein contained are not contested".

1. FACTS NOT ESTABLISHED

Among those alleged, relevant to the decision, none remained unproven.

IV – SUBSUMPTION OF FACTS TO LAW

The essential question to be decided and raised by the commercial company A…, Lda., in its request for arbitral pronouncement is the illegality of the additional assessments no. 2016…, of 3/6/2012, relating to IRC for the fiscal year 2012, in the amount of 41,659.67 € and no. 2016…, of 3/6/2012, relating to IRC for the fiscal year 2013, in the amount of 33,980.05 €, and their respective annulment.

The contested assessments are based on the AT's position that:

a) The Claimant recorded as expenses costs not accepted fiscally under article 23 of the CIRC: costs with legal services rendered to A…, Lda. by the Romanian law firm B…;

b) The Claimant recorded depreciation that exceeds the legal limit, contrary to article 23(2)(g) and article 31(2) of the CIRC: application of a depreciation rate of 8.33% to its wind turbines assuming a useful life period of 12 years.

Therefore, it is necessary to determine whether the costs with the legal services referred to in a) should be fiscally accepted and whether the depreciation rate applied by the Claimant and referred to in b) was correct.

Regarding the first question – the recording of costs with legal services rendered by law firm B… – it resulted from the established facts that the Claimant joined, in 2006, a consortium to participate in a bidding process for the acquisition, recovery and subsequent exploitation of mini-hydroelectric plants in Romania. As a result of that bidding process, the said consortium acquired 5 mini-hydroelectric plants located in …, in …. After this acquisition, it was verified that the acquired assets did not match the descriptions contained in the bidding documents, which led the said consortium to be the subject of court proceedings by the granting company, which intended to be compensated for contractual non-performance. As a member of the said consortium, the Claimant was also targeted by said court proceedings, being obligated to defend itself, and for this purpose contracted the legal services of law firm B…, to which it paid, in the year 2012, the sum of 28,796.80 and, in the year 2013, the value of 6,568.04.

These costs that the Claimant had to bear are a consequence of acts practiced in the context of the pursuit of its corporate purpose and their non-occurrence could have led to the Claimant's conviction in the said court proceedings for substantial compensation with obvious repercussions on its taxable profits.

Therefore, such expenses cannot fail to be considered "expenses (…) that demonstrably are indispensable for the realization of income subject to tax or for the maintenance of the source of production, in particular (…)" with "litigation (…)", in terms of article 23 of the Corporate Income Tax Code (CIRC).

The respective accounting support documents, that is, the Invoices issued by B… which are also contained in the present file (documents 13 to 24 attached with the arbitration request) were found, as legally required, in the accounting records requested by the AT, during the audit procedure.

The Claimant also made available to the AT all documents requested in the context of the tax audit procedure, provided, during the hearing of evidence, various documentation relating to the public tender to which it participated in Romania, in consortium (documents 4 to 11 attached with the arbitration request) and placed itself at the disposal to provide any other additional documentation (document 12 attached with the arbitration request), documentation which the AT did not request, just as it did not request, at that time, the translation of any documents.

On this basis, because it is understood that the expenses incurred with the legal services and lawyers of company B… constitute fiscally deductible costs in terms of article 23 of the CIRC, their disregard as such constitutes a violation of that legal provision, leading, necessarily, to the illegality of the adjustments made by the AT and, consequently, to the illegality of the assessments contested here, as far as this matter is concerned.

Regarding the other adjustments made by the AT, relating to its non-acceptance of the application of the depreciation rate of 8.33% to the Claimant's wind turbines, their legality depends on the determination of the useful life period of these equipment.

Let us see then.

In the audit conclusion report, the AT states that, from the consultation of Regulatory Decree 25/2009 of 14/9, it is verified that electricity production carried out through wind farms is not provided for in Table I and Table II, nor is there any reference therein to these wind farms or wind equipment. Only with Law no. 82 – D/2014 of 31/12 (article 23) was the rate to be applied defined, from 2015 onwards, being mentioned therein in the following terms: "Code … – Solar energy equipment, including in particular solar energy equipment, photovoltaic or wind energy equipment – rate of 8%".

The AT also invokes article 5(3) of Regulatory Decree 25/90 and article 31(2) of the CIRC, which provide that "with respect to elements for which depreciation or amortization rates have not been set in the tables referred to in article 5(1), those considered reasonable by the Tax Authority shall be accepted, taking into account the expected useful life period". The AT also alludes to a request for information (Inf. No. …/2015) to the DSIRC (Directorate of Corporate Income Tax Services) which states that the useful life of wind farms is 20 years.

Following the hearing, the AT, with respect to the fiscal years 2012 and 2013, maintained the initial corrections proposed with respect to the annual depreciation rate of 8.33% considered by the Claimant in those years and the depreciation rate of 5% accepted fiscally, calculated on the following items:

The Claimant in the request for constitution of the arbitral tribunal confirms that, with respect to the wind turbines of its wind farm, it used the rate of 8.33% corresponding to a useful life period of 12 years. That the same began to be depreciated, by the straight-line method (or constant quotas) from 2004, the year in which the wind turbines entered into operation. That in 2012 and 2013, as there was no legal rate defined to be applied, the rate that had been used was considered and which would be most appropriate for the estimated useful life period of the equipment, invoking technical and climatic reasons in support of the estimated useful life considered. Further stating that, in the insurance sector, a rate between 7% and 8% / year is used, corresponding to a useful life period between 12.5 years and 14.2 years and that the insurance policy provides for technical limitations on depreciation when the equipment reaches 10 years of life.

Also in the same sense, the Claimant states that Law 82-D/2014 of 31 December included wind turbines (wind energy equipment) in the list of Table II to Regulatory Decree 25/2009 with a depreciation rate of reference of 8% per year corresponding to a useful life of 12.5 years, recalling that the information from the DSIRC is subsequent to the entry into force of Law 82-D/2014 (the information is dated 29/05/2015). Also questioning the relevance in the clarification of whether the useful lives from the LNEG (National Energy and Geology Laboratory) study are maximum or minimum useful life, which, in the abstract, at the 20 years indicated by the AT as useful life, could correspond to a maximum useful life of 40 years.

In the examination of witnesses, the following clarifications provided by Engineer G… were relevant in this matter:

· The expected useful life of the equipment, with improvements is 20 years, but that given that its operability above 10/12 years and the increasing rise of repair costs it is usual for the depreciation of all components on an average basis of 12 years.

· That when reference is made to a useful life of 20 years, it is the maximum useful life.

From the testimony of Engineer H… it resulted that, depending on the conditions of insurance policies, the average depreciation rate may vary between 7% to 8% / year. And from the testimony of Dr. C… resulted confirmation that, since the date of entry into operation of the equipment, in 2004, until the present date, the depreciation rate of 8.33% has always been applied. He also clarified that, in the years prior to 2012 and 2013, there was never any correction or request for clarification by the AT regarding the depreciation rate used.

That is, it resulted from the evidence produced that the useful life of these wind turbines is estimated to be between 10 (the minimum) to 20 years (the maximum), taking into account factors related to the production technology itself, external factors, namely location, climatic conditions, speed, turbulence, gust regime, vertical component of local wind, economic factors, legal factors and the potential or expected use in regular conditions given its actual use and also the contractual and technical conditions of connection to the national electricity grid.

Article 17(1) of the CIRC establishes that the taxable profit of legal persons is constituted by the algebraic sum of the net result of the period and the positive or negative changes in assets verified in the period and not reflected in that result, determined on the basis of accounting and possibly corrected under the terms of the IRC code. (emphasis ours)

In 2004, the year of entry into operation of the equipment and the beginning of the accounting depreciation thereof, the Official Chart of Accounts (POC), approved by Decree-Law 410/89 of 21/11 and Regulatory Decree 2/90 of 12/1, was in effect.

The POC identifies, as one of the characteristics of financial information, Comparability, which clarifies that operations must be recorded consistently by the company and throughout its life, such characteristic being based on the accounting principle of Consistency which considers that accounting policies should not be altered from one fiscal year to another. (It should be noted that at the time the POC did not establish the differentiation between Accounting Policies and Changes in Accounting Estimates, which was only included in the national accounting standards, from 2010 onwards with the entry into force of the SNC).

Article 5.4.1 of the POC establishes that elements of fixed assets, when they have a limited useful life, are subject to systematic amortization during that period. And that the methods of calculation regarding in particular amortizations must be disclosed in the Notes (article 8.3 of Annex / POC).

It should be noted that, in terms of the accounting standards applicable at the time, on 18/12/1996, Accounting Guideline 18 – Objectives of Financial Statements and Generally Accepted Accounting Principles was approved by the General Council of the Accounting Standards Commission, which was replaced and adjusted on 22/06/2005 – Accounting Guideline 18/05.

This reference is important because, already at the time, accounting regulations dealt with, as they do today, the aspects related to the definition of the useful life of equipment or any other tangible fixed asset, in terms identical to those currently (that is, since 2010) used in the accounting regulations of the SNC – Accounting Standards System. And because Accounting Guideline 18/05 defined a hierarchy of accounting standards which was as follows:

· POC

· Accounting guidelines and technical interpretations of the CNC and subsidiarily

· International Accounting Standards adapted in the EU and the IAS/IFRS.

The Accounting Standards System – SNC, approved by Decree Law 158/2009 of 13/7 and derived from a continuous process of recommendations and obligations arising from the EU which entered into force on 01/01/2010, is based on the subsidiary standards referred to in the preceding article, maintaining the requirements of comparability and consistency in the presentation of Financial Statements and creating a model based on Standards (NCRF – Accounting Standards for Financial Reporting).

NCRF 7 – Tangible Fixed Assets (applicable to the equipment in question) establishes in § 6: depreciation (amortization) is the systematic imputation of the depreciable amount of an asset over its useful life. And useful life is: the period during which an entity expects an asset to be available for use (emphasis ours) or the number of production units or similar that an entity expects to obtain from the asset.

That is, the depreciation rate to be used will be that which results from a useful life estimated by the entity, on a time basis, or on a usage/production basis.

Article 57 states that "the useful life of an asset is defined in terms of the expected utility of the asset to the entity" and "the estimation of the useful life of the asset is a matter of judgment based on the entity's experience with similar assets". (emphasis ours)

Moreover, it should be clarified that since amortization/depreciation is calculated based on useful life, it is treated in the standards as an accounting estimate, regulated in NCRF 4.

See § 27, which states that "as a consequence of the uncertainties inherent in business activities, many items in financial statements cannot be measured with precision and can only be estimated. The estimate involves judgments based on the latest available information. For example, estimates may be required for:

(…) d) The useful life of, or the expected consumption model of future economic benefits incorporated in depreciable assets. (…)."

It is in this context of accounting regulations, based on experience, studies, information from insurance companies, that the Claimant, A…, Lda., will have initiated the depreciation of the equipment based on an estimated useful life of 12 years, applying to cost, an annual depreciation rate of 8.33%, based on constant quotas or straight-line method, ensuring the comparability of Financial Statements and the consistency of the calculation method.

Regulatory Decree 2/90 defines in its article 3 that the useful life of an element of movable assets is, for fiscal purposes (emphasis ours), the period during which its value is fully reintegrated or amortized.

Considering that:

a) The minimum useful life period is that which is deduced from the rates that may be accepted fiscally according to the method of constant quotas; and

b) The maximum useful life period is that which is deduced from a rate equal to half of that referred to in the preceding paragraph.

Referring (in article 3(5) and article 19) to its disregard as a fiscal expense – general rule – when the depreciation recorded does not fall between the limits referred to in the preceding point, that is, between the maximum rate and the minimum rate.

Recall that in article 5(3) of the already mentioned Regulatory Decree it is stated that: "With respect to the elements mentioned in the preceding number for which depreciation or amortization rates have not been set in the tables referred to in article 5(1), those considered reasonable by the Directorate General of Contributions and Taxes shall be accepted, taking into account the expected useful life period".

This Regulatory Decree applied, for IRC purposes, with respect to tax periods beginning from 01/01/1989 and until 31/12/2009, the date from which it was revoked by Regulatory Decree 25/2009 of 14 September, which entered into force on 01/01/2010.

In substance, this statute, as far as the case is concerned, changed nothing regarding the content of the already mentioned articles 3 and article 5(3). The latter, in particular, with the wording given by Regulatory Decree 4/2015 of 22/4, states that "with respect to elements for which depreciation or amortization rates have not been set in the tables referred to in article 5(1), those considered reasonable by the Tax and Customs Authority shall be accepted, taking into account the expected useful life period of those elements".

Therefore, and summarizing:

The company A…, Lda., from 2004 to 2013 consistently practiced a depreciation rate of 8.33% corresponding to an expected useful life of the equipment of 12 years.

During the fiscal years 2004, 2005, 2006, 2007, 2008, 2009, 2010 and 2011, the depreciation expenses thus recorded were included in the determination of the annual net result and the corresponding taxable base for IRC purposes.

No evidence was presented in the case demonstrating that, over those years, the Tax and Customs Authority proposed any correction to the depreciation recorded, which were included in the calculation of the taxable base in definitive terms.

It can therefore be inferred that from 2004 to 2011 the Tax and Customs Authority considered as reasonable and accepted the depreciation rates recorded.

In the fiscal years 2012 and 2013 (years relating to case 234/2016-T), the company did not alter the estimate of the useful life of the equipment, consistently maintaining the application of the depreciation rate of 8.33% / year which falls between the minimum rate of 5%, corresponding to the maximum useful life period of 20 years and the maximum rate of 10%, corresponding to the minimum useful life period of 10 years (fiscal basis).

It should also be noted that the audit conclusion report is dated 22/12/2015, supported by an opinion dated 29-05-2015, that is, all these documents are subsequent to Law 82-D/2014, which included a new code: "… – Solar energy equipment, including in particular photovoltaic solar energy equipment or wind energy equipment; applying the reference depreciation rate of 8% per year".

Therefore, it does not appear to be understandable that in the year 2015 – the year of the tax audit – the reasonableness criterion which the AT had the right to use in terms of article 5(3) of Regulatory Decree 25/2009 of 14 September, had not taken into account the following fundamental aspects:

· The use of the 8% rate resulting from more current legislation and in the absence of the reference rate with legal basis in previous years.

· The fact that it can be inferred that the AT, from 2004 to 2011, considered the rate of 8.33% to be reasonable.

· The fact that the company complied with the accounting requirements regarding the definition of useful life, prioritizing its consistency throughout the fiscal years.

In these terms, these adjustments made by the AT are considered illegal and, consequently, the additional assessments here contested are also considered illegal, as far as this matter is concerned.

The Claimant requests reimbursement of the amount paid and indemnification interest, it having been proven that it paid the contested assessments in the total amount of € 75,639.72 (documents 29 and 30).

Article 43(1) of the General Tax Law (LGT) establishes that "indemnification interest is due when it is determined (…) that there was an error attributable to the services which resulted in the payment of tax debt in an amount greater than the legally due".

In the case at hand, the error which affected the assessments is attributable to the AT.

Therefore, the Claimant is entitled to be reimbursed for the amounts it paid (articles 100 of the LGT and 24(1) of the RJAT) and indemnification interest from the date of payment, 10-03-2016, until reimbursement, at the legal supplementary rate, in terms of articles 43(1) and (4), and 35(10) of the LGT, article 559 of the Civil Code (CC) and Ordinance no. 291/2003 of 8 April.

V – DECISION

In accordance with the foregoing, this Arbitral Tribunal decides:

a) To judge the arbitration request entirely well-founded and, in consequence, to declare illegal the assessments nos. 2015…, relating to the year 2012, and 2015…, relating to the year 2013, annulling them, with all the legal consequences of a tax-legal nature legally applicable.

b) To order the AT to reimburse the total amount of € 75,639.72, plus indemnification interest at the legal rate, with the proper legal consequences.

c) To order the Defendant to pay the costs of the proceedings.

VI – VALUE OF THE CASE

The value of the case is set at € 75,639.72.

VII – VALUE OF COSTS

The costs are computed in the amount of € 2,448.00, in terms of Table I attached to the Regulation of Costs in Tax Arbitration Proceedings.

Let notification be made.

Lisbon, 23 December 2016.

The arbitrators,

(José Baeta de Queiroz)

(Cristina Aragão Seia)

(Victor Simões)