Summary
Full Decision
ARBITRAL DECISION
I. REPORT
On 15 May 2018, A..., Lda., (hereinafter simply "Claimant") with the Tax and Customs Registration Number (NIPC) ... and with registered office at ..., n.º ..., ...-..., Cascais, requested, pursuant to the provisions of paragraph a), of section 1, of article 2 of Decree-Law no. 10/2011, of 20 January, which approved the Legal Framework for Tax Arbitration (hereinafter "LFTA"), and of Ordinance 112-A, of 22 March, the constitution of an Arbitral Tribunal, in which the Tax and Customs Authority (hereinafter simply "Respondent" or "TA") is named as Respondent, with a view to the declaration of illegality and consequent annulment of the act of additional assessment of Corporate Income Tax (IRC) and compensatory interest with number 2017..., in the total amount of € 50,798.94 and respective Compensation Statement with number 2018..., all relating to the year 2013.
The request for constitution of the Arbitral Tribunal was accepted by the Esteemed President of CAAD and notified to the Respondent on 22 May 2018.
The Ethics Council designated the undersigned as arbitrator, who communicated acceptance of the appointment within the applicable timeframe.
On 05 July 2018, the Parties were duly notified of that designation, and did not express any intention to challenge the designation of the arbitrator, in accordance with the combined provisions of article 11, section 1, paragraphs a) and b) of the LFTA and articles 6 and 7 of the Code of Ethics.
In accordance with the provisions of paragraph c), of section 1, of article 11 of the LFTA, the singular arbitral tribunal was constituted on 25 July 2018.
Notified to submit its response, the TA presented a reply in which it petitioned that the request for arbitral decision be judged as unfounded due to lack of legal foundation, maintaining in the legal system the contested tax acts and, accordingly, absolving the Respondent entity of the claim.
The Parties submitted arguments (the Claimant on 06 November 2018 and the Respondent on 07 November 2018), maintaining the arguments already presented.
The Claimant further requested, on 09 November 2018, the attachment of a document seeking to prove the cost of reducing the reference value of the swap contract with one of the financing institutions, with the Respondent arguing for the withdrawal of that request due to untimeliness.
Summary of the Parties' Positions
a. Of the Claimant:
In accordance with the request for arbitral decision and arguments, the Claimant contends that:
- The Claimant is a small/medium-sized enterprise in the construction and real estate development sector;
- With the global financial crisis, it sought to safeguard, to the extent possible, the unpredictability of interest rate developments, containing it within pre-fixed limits, in order to control the effects of an unbearable rise in rates;
- For this purpose, it adhered to interest rate swap contracts that were proposed to it by the financing banks;
- The evolution of interest rates in the market led to these contracts being initially very positive for the Claimant, which was not the case, in particular, with respect to the year 2013, with the Claimant having incurred payments of interest to the financing institutions;
- In parallel, due to the crisis in the real estate development sector between 2011 and 2014, the Claimant reduced its exposure to bank financing which, at the end of 2013, amounted to a total of € 24,048,599.39;
- Despite the amount of bank financing exposure, the swap contracts in effect in 2013 covered interest rate risk up to the amount of € 41,000,000.00;
- Although the Claimant could have reduced the scope of swap contracts in accordance with bank debt, this would have a very high cost given the contractual terms;
- Without prejudice to the TA's position, the Claimant contends that the interest incurred should be deducted as costs for purposes of determining taxable profit for IRC purposes.
b. Of the Respondent:
In turn, in accordance with the reply and arguments presented, the Respondent argues that:
- Given the facts ascertained, the swap contracts cover a real interest rate risk in an amount exceeding that of the portfolio of financial liabilities that share the risk being covered;
- Therefore, the expenses incurred with swaps corresponding to the excess of risk coverage, beyond bank debt values, are not considered hedging operations and, as such, cannot be considered for tax purposes since they exceed the entirety or part of a portfolio of financial liabilities that share the risk being covered;
- Thus, these payments cannot, in accordance with the IRC Code, be accepted as costs for tax purposes, to the extent that they exceed the amount of bank debt in 2013, in compliance with the provisions of articles 23 and 49 of the IRC Code;
- Given the foregoing, the Respondent contends that the swap contracts entered into by the Claimant could not, and were not, considered as hedging operations in part in accordance with the provisions of paragraph b) of section 6 of article 49 of the IRC Code.
II. CASE MANAGEMENT
1. The Arbitral Tribunal is competent and was regularly constituted, in accordance with articles 2, section 1, paragraph a), 5 and 6, all of the LFTA.
2. The parties have legal personality and capacity, are legitimately interested and are legally represented, in accordance with articles 4 and 10 of the LFTA, and article 1 of Ordinance no. 112-A/2011, of 22 March.
3. No exceptions were raised that merit consideration.
4. The proceedings do not suffer from defects that would invalidate them.
5. With respect to the Claimant's request to attach a document after the arguments, considering that evidence shall be submitted with the request for arbitral decision (see article 10, section 2, paragraph d) of the LFTA), it should be withdrawn from the case file, taking into account the evidence produced with the request for arbitral decision, the reply and the respective arguments.
III. FINDINGS
III.1. FACTS
The factual matter relevant to the understanding and decision of the case, after critical examination of the documentary evidence attached to the initial petition, the administrative proceedings, the reply and the arguments of the Claimant and the Respondent, is established as follows:
A – Proven Facts
a. The Claimant is a small/medium-sized enterprise in the construction and real estate development sector;
b. The Claimant entered into swap contracts with financing banks to reduce its exposure to interest rate fluctuations;
c. At the end of 2013, the Claimant's bank debt was € 24,048,599.39;
d. In the same period, the swap contracts in effect covered interest rate risk up to the amount of € 41,000,000.00;
e. Given the contractual terms assumed, the Claimant, in 2013, had to make interest payments to the financing banks, which related to the value covered by the swap contracts;
f. The value covered by the swap contracts was, at that date, greater than the value of the Claimant's bank exposure;
g. The Claimant did not have, in the tax file, supporting documentation for the referenced contracts and charges incurred, having provided that information at the request of the Respondent in the context of the inspection.
B – Unproven Facts
No facts relevant to the discussion of the case were found to be unproven.
III.2. REASONING
Regarding factual matters, the Tribunal does not have a duty to rule on all matters alleged, but rather has a duty to select those matters that are relevant to the decision, taking into account the cause (or causes) of action that supports the claim presented by the Claimants.
Regarding the evaluation of evidence, the Tribunal formulates its judgment, paying attention to the principle of free evaluation, based on the examination and assessment it makes of the means of proof brought into the proceedings and in accordance with its experience.
Thus, the Tribunal's conviction was based on the body of documents attached to the case file as well as on the positions taken by the Claimant and the Respondent.
III.3. ON THE LAW
1. ISSUE TO BE DECIDED:
Given the foregoing, the disputed question in the present proceedings, and to which a response is required, shall be, in simple terms, as follows:
Does the IRC Code prevent the deduction, as a tax cost, of interest incurred in swap contracts to the extent that they relate to the part covered by the contract that exceeds the actual bank exposure (amounts owed)?
2. LEGAL GROUNDS:
Ultimately, what is at issue here is the question of whether interest incurred with swap contracts, in the part intended to cover the part covered by the respective contract and which exceeds the bank debt at that time, can or cannot be considered as costs for tax purposes.
In this respect, it is important to recall the fundamental rule on this matter – article 23 of the IRC Code – when it states that "[...] all expenses and losses incurred or borne by the taxpayer to obtain or ensure income subject to IRC are deductible."
Being one of the most controversial topics – and widely discussed – in national jurisprudence, it is important to note the clarifications that have been advanced by Portuguese courts, albeit by way of mere example:
"In the understanding that doctrine and jurisprudence have been adopting for the purpose of ascertaining the indispensability of a cost (cfr. art. 23 of the CIRC in the version in force in 2001), the TA cannot scrutinize the soundness and appropriateness of the company's management's economic decisions, on pain of interfering with the company's freedom and management autonomy. Thus, a cost or loss will be accepted fiscally if, in a judgment made at the moment it was incurred, it is appropriate to the company's productive structure and to the obtaining of profits, even if it turns out to be an unfruitful or economically ruinous economic operation, and the TA can only disregard those that do not fall within the scope of the taxpayer's activities and were incurred, not in the interest of the taxpayer, but for the pursuit of other objectives (when it can be concluded, according to the common rules of experience, that it had no potential to generate benefits). [...]. [a] requirement of necessary and direct causality between costs and benefits has long been rejected by doctrine and jurisprudence." (Supreme Administrative Court Decision of 28/6/2017, case no. 0627/16);
"[...] the concept of indispensability of costs is an indeterminate concept, and it has fallen to jurisprudence to fill it, but in a casuistic manner, and from such work no concrete definition of it has emerged. However, that indeterminacy does not allow the Tax Administration, for its relevance, to be able to do so under the criterion of its reasonableness or even necessity or convenience. [...] The power that the Industrial Contribution granted to DGCI in article 26 of CI and which allowed it to reject the deductibility of certain costs no longer exists. The rule in accordance with the CIRC is that expenses correctly accounted for are tax costs. As the same judgment also says ... «the criterion of indispensability was created by the legislator not to allow the Tax Administration to interfere in company management by dictating how it should apply its means but to prevent the tax consideration of expenses that, although known as costs, do not fall within the scope of the company». Rui Duarte Morais argues, in Notes on IRC, Almedina Coimbra, 2007, p. 87, that the cost must be considered indispensable whenever the charge that originates it stems from «a genuine business motivation – the understanding of the company's partners and/or managers, who alone have the power to decide on the company's interest». Following, moreover, António Moura Portugal who, in The Deductibility of Costs in Portuguese Tax Jurisprudence, Coimbra Publisher, 2004, pp. 133 et seq., argues that «indispensability must be interpreted according to the company's purpose. The use of the reasonableness criterion as a basis for quantitatively limiting the charges incurred by taxpayers is no longer tolerable. Indispensability should be assessed based on a positive judgment of subsumption in the company's activities, which by its nature should not be subject to scrutiny by Tax Law, which should not interfere with, much less evaluate, the taxpayer's business decisions. Indispensable costs are thus equivalent to expenses incurred in the interest of the company. The fiscal deductibility of the cost should depend only on a justified relationship with the company's productive activity, and this indispensability is verified whenever, by operation of the theory of the specialization of legal persons, the company's operations fall within its capacity by subsumption to its respective business purpose and especially insofar as they are connected with the obtaining of profit, whether directly or indirectly»." (Supreme Administrative Court Decision of 5/11/2014, case no. 0570/13);
"The legal interpretation of the concept of «indispensability», at the time contained in art. 23 of the CIRC, has been, as doctrine and jurisprudence show, equated with costs incurred in the interest of the company; expenses borne within the scope of activities resulting from its business purpose. Only when expenses result from decisions that do not meet such requirements should they be disregarded. Now, given that legal entities have a scope or business objective defined in their bylaws, with a view to achieving the purpose for which such legal entities are formed – the obtaining of a surplus to be distributed among the partners – then acts of management that contribute to such purpose must constitute the activities of companies. Productive activity should not be understood in a restrictive sense, but rather in a broad sense, meaning activity related to an income-producing source of the entity bearing the expenses. [...]. [...] a company's «activity» does not end, as often seems to emerge from some interpretations, in the set of operational acts. «Activity» is also the set of operations that have the purpose of making investments or disposing of assets, acquiring financial interests and their subsequent disposal, the application of liquidity in short-term investments or securities and its management, receipts and payments resulting from operating and non-operating income and expenses, and many others not expressly referred to here. The management of companies has, in essence, the purpose of obtaining a surplus from the use of the assets held by economic-business entities. Such assets are, even by virtue of their accounting-normative classification, divided into different types: tangible fixed assets/fixed assets (e.g., machines devoted to production), intangible assets (e.g., manufacturing patents), financial assets (e.g., equity interests), non-current assets held for sale (e.g., a machine that is no longer devoted to production and is intended to be disposed of in the short term), inventories/stock (e.g., raw materials) and so on. Comprising this broad range of assets the means that management has to generate income and surpluses, it is natural that the purchase of physical assets for investments and their possible disposal (disinvestment), the buying and selling of financial interests, the application of liquidity, receipts and payments from activities, all of this forms part of what are considered normal or appropriate acts of management of a company." (Arbitral Decision of 8/4/2017, case no. 480/2016-T);
"Article 23, section 1, of the CIRC establishes the rule that «expenses are considered those that are demonstrably indispensable for the realization of income subject to tax or for the maintenance of the income-producing source». [...]. According to Tomás Tavares, «the legal notion of indispensability is thus outlined from an economic-business perspective, by fulfillment, directly or indirectly, of the ultimate motivation for obtaining profit. Indispensable costs are equivalent to expenses incurred in the interest of the company, or in other words, in all acts abstractly capable of being subsumed in a profit-making profile. (…) Indispensability is subsumed to any and all acts carried out in the interest of the company... The legal notion of indispensability thus represses acts inconsistent with the company's purpose, not capable of being entered into the social interest, especially because they do not aim at profit»." (Arbitral Decision of 6/12/2016, case no. 341/2016-T).
Now, it clearly results from the jurisprudence referenced here, and beyond, that the concept of cost indispensability should be assessed from the company's perspective, at the time the cost is incurred, regardless of whether the decision was or was not economically sound.
Thus, and without disputing the appropriateness of the decision to contract swap-type instruments for protection against interest rate fluctuation risk given the Claimant's bank exposure, it seems to clearly follow from the aforementioned jurisprudence that, since this is a protection instrument directly related to the Claimant's activities, which the Respondent does not contest, the interest related to it (the costs incurred) should naturally be considered deductible.
And, having reached this point, the Respondent's argument does not prevent this, namely that "the expenses incurred with swaps corresponding to the excess of risk coverage, beyond bank debt values, are not «...considered hedging operations... and, as such, cannot be considered for tax purposes since they exceed the «...entirety or part of a portfolio of ... financial liabilities that share the risk being covered...»".
In fact, despite the Respondent's direct reference to the provisions of article 49 of the IRC Code, the truth is that it subsumes the facts to a rule without substantiating the logical reasoning that underlies it, thereby drawing consequences that the rule does not contemplate.
From the analysis of the rule in question, it does not result, in any of its provisions, the disregarding of costs incurred with swap interest in the case where the amount covered exceeds the actual bank exposure.
Nor does the Respondent seek to base its decision on the fact that the Claimant did not initially have in its tax file properly organized documentation regarding this matter, since, insofar as argued in the proceedings and not contested, the requested information was duly submitted in the context of the inspection.
Finally, it may always be said, following, in this context, the line of reasoning of the Claimant, that if the interpretation followed by the Respondent were to be accepted, which is contemplated only for the sake of completeness of reasoning, the entirety of the interest incurred would always have to be disregarded (and not only to the extent that the amount covered exceeds the amount of bank debt) insofar as the rule invoked by the Respondent itself refers to the operation (of hedging) as a whole, requiring, were that to be the case, its complete disregarding.
IV. DECISION
Based on the facts and legal grounds set out above and, in accordance with article 2 of the LFTA, the Arbitral Tribunal decides:
I) To fully uphold the request for arbitral decision;
II) To annul the additional assessment of Corporate Income Tax (IRC) and compensatory interest with number 2017..., in the total amount of € 50,798.94 (fifty thousand, seven hundred and ninety-eight euros and ninety-four cents) and respective Compensation Statement with number 2018... with the consequent refund of the amounts unduly paid;
III) To condemn the Respondent to pay compensatory interest due from the date of payment of the tax.
CASE VALUE: In accordance with the provisions of article 306, sections 1 and 2, of the Code of Civil Procedure, 97-A, section 1, paragraph a), of the Code of Tax Procedure and 3, section 2, of the Regulation on Costs in Tax Arbitration Proceedings, the case is assigned a value of € 50,798.94 (fifty thousand, seven hundred and ninety-eight euros and ninety-four cents).
COSTS: Calculated in accordance with article 4 of the Regulation on Costs in Tax Arbitration Proceedings and Table I attached thereto, in the amount of € 2,142.00 (two thousand, one hundred and forty-two euros), borne by the Respondent given the success of the request for arbitral decision.
Lisbon, 24 January 2019
The Arbitrator,
José Calejo Guerra
Text prepared by computer, in accordance with section 5 of article 131 of the Code of Civil Procedure, applicable by referral of paragraph e) of section 1 of article 29 of Decree-Law 10/2011, of 20 January.
The drafting of this decision is governed by the 1990 Orthographic Agreement.
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