IRC Tax Ruling 262/2013-T: Non-Resident Entity Permanent Establishment Taxable Income

ARBITRAL AWARD

The arbitrators, Judge Dr. José Poças Falcão (presiding arbitrator), Dr. António Rocha Mendes and Dr. Armindo Fernandes Costa (arbitrator members), designated by the Deontological Council of the Administrative Arbitration Center to form the Arbitral Tribunal, constituted on 27-01-2014, agree as follows:

I REPORT

A…, SPA, NIF 9…, with registered office in … Italy, pursuant to the provisions of Articles 2nd and 10th of Decree-Law No. 10/2011, of 20 January (Legal Regime for Tax Arbitration, hereinafter "LRTA"), submits a request for arbitral pronouncement requesting:

a) The annulment of the tacit dismissal of the administrative appeal;

b) The allowance of the aforementioned administrative appeal;

c) The annulment of the Corporate Income Tax (IRC) assessments for the fiscal years 2008, 2009 and 2010, as well as the corresponding assessments of compensatory interest;

d) Condemnation of the Tax Authority to payment of compensation for undue provision of guarantee.

The Claimant did not proceed to appoint an arbitrator, wherefore, pursuant to Article 6, paragraph 2, subsection a), of the LRTA, the signatories were designated by the President of the Deontological Council of the Administrative Arbitration Center to integrate the present collective Arbitral Tribunal, having accepted the assignment within the deadline and other legal terms.

On 10-01-2014 the parties were duly notified of such designation and did not manifest intention to refuse the designation of the arbitrators, pursuant to the combined terms of Article 11, paragraph 1, subsections a) and b) of the LRTA and Articles 6 and 7 of the Deontological Code.

Thus, in conformity with the provision of subsection c) of paragraph 1 of Article 11 of Decree-Law No. 10/2011, of 20 January, in the wording introduced by Article 228 of Law No. 66-B/2012, of 31 December, the collective arbitral tribunal was constituted on 27-01-2014.

The Tax and Customs Authority (Tax Authority) filed a reply, arguing that the request for arbitral pronouncement should be judged as unfounded.

On 24-03-2014, the meeting provided for in Article 18 of the LRTA took place, in which the claimant dispensed with the production of the listed testimonial evidence, and the Tribunal, with the agreement of the parties, decided that the final submissions would be produced in writing. Only the Tax Authority submitted submissions[1], concluding by the total lack of merit of the claim.

II. CASE MANAGEMENT

The arbitral tribunal was regularly constituted and is materially competent, in light of the provision in Articles 2, paragraph 1, subsection a), and 30, paragraph 1, of the LRTA.

The parties have legal personality and capacity and are legitimately constituted (Articles 4 and 10, paragraph 2, of the same statute and Article 1 of Order No. 112-A/2011, of 22 March).

The case does not suffer from nullities and no issues were raised that could prevent the appreciation of the merit of the case.

III. PROVEN FACTS

At issue is the determination of the taxable matter calculated by the Tax Authority within the scope of external inspection actions carried out on the Claimant, in the matter of Corporate Income Tax (IRC), relating to the fiscal years 2008 to 2010.

There is no disputed factual matter, and it must be considered established in the probation, having regard to what was alleged by the parties and the evidence contained in the administrative proceedings, the following facts:

a) The Claimant, which is a company under Italian law with registered office and effective management in that country, entered into, on 19/01/2007, a contract for the supply and installation of equipment with the Portuguese company B…, S.A. (B...), whose execution extended through the fiscal year 2011.

b) During the period of execution of the supply contract, the Claimant remained registered as a non-resident taxpayer without permanent establishment, for which reason it did not file the annual declarations (Model 22) relating to IRC for those fiscal years.

c) The Claimant invoked the convention to eliminate double taxation entered into between Portugal and Italy, delivering to B... the corresponding certificates of tax residence, for which reason no withholding at source of IRC was made on the amounts paid by B... to the Claimant.

d) The aforementioned supply contract concerns the supply and installation of equipment at B...'s factory in …, with the total price of the contract initially agreed amounting to € 26,670,000.00.

e) On 22/10/2009 the parties agreed on an addendum to the contract, pursuant to which they agreed on the following: i) payment of an additional amount of € 1,170,000.00 relating to equipment not included in the initial contract; ii) the obligation of the Claimant to pay a penalty for delays in execution of the work in the amount of € 3,333,750.00; iii) and the obligation of the Claimant to pay compensation for defects in the work in the amount of € 2,700,000.00.

f) In June 2010 the Claimant and B... proceeded to issue the following documents:

g) In addition to the operations developed within that contract, the Claimant provided in 2009 a provision of services and a transfer of goods, as follows detailed:

h) The costs associated with the contract, incurred by the Claimant in each fiscal year, and the percentage of completion calculated in accordance with paragraph 4 of Article 19 of the Corporate Income Tax Code, were as follows:

i) In October 2012 the Claimant was subject to an inspection action carried out by the Tax Inspection Services of …, of general scope, for the fiscal years 2008, 2009, 2010 and 2011.

j) Within the scope of that inspection action, the Tax Authority, concluding that the Claimant, by virtue of the execution of the aforementioned supply contract, had a permanent establishment in Portugal in the fiscal years 2008 to 2011, proceeded to make the corresponding technical corrections to the taxable matter, establishing the values as follows detailed:

k) The Claimant agrees with the existence of a permanent establishment in Portugal and with the method of allocation of the taxable profit attributable to said permanent establishment, i.e. the method of percentage of completion (pursuant to paragraphs 1 and 2 of Article 19 of the Corporate Income Tax Code). The Claimant and the Respondent do not diverge, either, as to the value of the revenues and expenses considered for the purpose of determining the collective income.

l) The Claimant does not agree, however, with the manner of determining the taxable income underlying the technical corrections to the taxable matter made by the Tax Authority, understanding that the method of allocation of income to each fiscal year was not correctly applied, in light of the applicable accounting and tax rules.

m) For this reason, the Claimant filed, on 30/04/2013, an Administrative Appeal, which was considered tacitly dismissed, pursuant to Article 57, paragraph 1 of the General Tax Law.

n) The Claimant, in order to suspend the fiscal enforcement proceedings No. … 2013 …, relating to IRC for 2008, and No. … 2013 …, relating to IRC for 2009, provided bank guarantees for the global amount of € 137,833.62.

IV – REASONING

THE LAW

Question to be Decided

The question to be decided consists merely of a matter of law, more specifically in determining the manner of determining the taxable matter subject to IRC, to be allocated to each fiscal year, in light of the applicable accounting and tax rules for the taxpayer (non-resident with permanent establishment).

Considering that the activity carried out by the Claimant concerns a work of multi-year character, the determination of the taxable matter follows the rules established in Articles 18 and 19 of the Corporate Income Tax Code.

Pursuant to these articles, the allocation to each fiscal year of the results of the execution of multi-year construction contracts is carried out by means of the criterion of percentage of completion, which consists of the inclusion in taxable profit of the total value of the contract in the proportion between the expenses incurred up to that date and the sum of such expenses with those estimated for the conclusion of the contract.

The Claimant and the Respondent are in agreement as to the application of the criterion of percentage of completion of the work, as to the proportion of completion to be considered at the end of each taxation period, as to the estimated expenses for the conclusion of the work and as to the losses suffered by the Claimant in the said work[2].

The parties disagree only as to the total price of the contract, a value which, as we have seen, serves as the basis for the calculation of the taxable matter attributable to each economic fiscal year.

The Claimant understands that this value corresponds to:

• In the fiscal years 2007 and 2008, the amount of € 26,670,000.00, i.e., the price initially agreed between the Claimant and B...; and

• In the fiscal years 2009 to 2011, the amount of € 21,806,250.00, i.e., the price that results from the following adjustments made in 2009:

  • An increase in the value of the contract, relating to the supply of additional equipment, in the amount of € 1,170,000; and
  • A reduction of the value of the contract, relating to the amounts of € 3,333,750.00 and € 2,700,000.00, resulting from the penalty and compensation for defects and delays in the execution of the work, in a total of € 6,033,750.00.

The Tax Authority disagrees with the thesis propounded by the Claimant, both as regards the value initially calculated as revenues of the contract, and as regards the breakdown of that amount (i.e., considering different amounts before and after the 2009 addendum).

The Tax Authority understands that the correct value of contract revenues is the amount of € 27,840,000.00.

This amount corresponds to the initially agreed price of € 26,670,000.00 plus the value of the additional equipment, the supply of which was agreed in the addendum to the contract, in the amount of € 1,170,000.00.

That is, the Tax Authority understands that the amount of € 6,033,750.00 resulting from the penalty and compensation for defects and delays in the execution of the work is not deductible from the value of the contract revenues, arguing that these are extraordinary costs that do not affect the value of the contract.

Based on the theses sustained by the parties, the price of the contract would be:

Based on these values, the taxable matter for each fiscal year would be:

According to the Claimant:

According to the Respondent:

Disagreement as to the Value of Contract Revenues

As we have seen, the applicability of the accounting method of percentage of completion to multi-year construction contracts is provided, for tax purposes, in Article 19 of the Corporate Income Tax Code. This article, both in its current wording and in the wording in force until the 2014 Corporate Income Tax Reform, contains no rule regarding the manner of calculating the contract price. Therefore, pursuant to Article 17 of the Corporate Income Tax Code, the accounting rules in force apply for the purpose of determining taxable revenues, in particular Accounting Guideline No. 3, until fiscal year 2009, and Accounting Standard for Financial Reporting (NCRF) 19, in subsequent fiscal years (see paragraph 42 of NCRF[3] 19).

Pursuant to both accounting standards, under the percentage of completion method, the revenue and costs associated with the construction contract must be recognized as revenue and expenses, respectively, with reference to the stage of completion of the contract activity at the date of the balance sheet (see paragraph 22 NCRF 19).

For these purposes, pursuant to paragraphs 11 and 12 of NCRF 19[4], the contract revenue is measured at the fair value of the consideration received or to be received and must comprise: the initial amount of revenue agreed in the contract; and variations in work, claims and incentive payments of the contract.

Because these are contracts that develop over several fiscal years, the contract revenue must be determined on the basis of estimates, which naturally may be affected by a variety of uncertainties and which depend on the outcome of future events.

These estimates often need to be revised as events occur and uncertainties are resolved. Therefore, accounting standards allow the value of the contract to vary between periods, expressly indicating in NCRF 19 the following situations in which this may occur:

• A contracted entity and a customer may agree variations or claims that increase or decrease the contract revenue in a period subsequent to that in which the contract was initially agreed;

• The amount of contract revenue may decrease as a consequence of penalties resulting from delays caused by the contracted entity in completing the contract.

When this is so, the revised estimates must be used in determining the amount of revenue and expenses recognized in the income statement in the period in which the change is made and in subsequent periods (see paragraph 38 of NCRF 19).

Now, in the case in question, following the addendum to the contract agreed in 2009, the estimate of the contract value should be adjusted, in accordance with accounting standards, through the increase of the value of supplementary work and the deduction of the value of penalties for delays (see paragraphs 11 and 12 of NCRF 19).

Note, however, that the Claimant did not prepare its accounting in accordance with Portuguese accounting standards nor did it file income declarations in the periods in question.

The issue of contract value recognition arises only in 2012, in the context of the tax assessment carried out by the Respondent, and the respective appeal by the Claimant.

At that time the construction contract was already completed, with the exact values of the expenses incurred and the total revenues known, which is why there is no justification for performing the calculation and allocation of the income from that contract on the basis of estimates which are known to be incorrect.

For the need to use estimates in measuring contract results constitutes an important limitation in the presentation of financial information. The use of the percentage of completion method results in significant distortions in the results established in each fiscal year, whenever the estimates of costs to be incurred do not prove to be correct.

For that reason, they are only accepted as a method of allocation of taxable profit when they are deemed to be reliable, and in other cases alternative methods are applied, in particular the zero profit method provided for in the accounting standards and admitted, for tax purposes, by paragraph 3 of Article 19 of the Corporate Income Tax Code.

Thus, given that the parties at the time of the assessment and the contestation were in possession of all the final values in relation to the contract in question, there is no justification for resorting to the estimates that would have been made in those fiscal years (based on the information then available), since those estimates, we now know with certainty, are incorrect for the determination and allocation of the taxable profit of the Claimant.

Thus, the value of the contract to be used for the purpose of determining the respective revenues, through the application of the percentage of completion method, should correspond to the amount of € 21,806,250.00.

Resulting in the following allocation of the overall loss of the contract:

For this reason, the position of the Claimant is accepted, which does not conform with the calculation of the taxable matter allocated to the permanent establishment in the years 2008 to 2010.

Regarding Compensation in Case of Undue Guarantee

The Claimant further makes a claim for compensation for the undue guarantees it provided, in the global amount of € 137,833.62.

By virtue of the provision in subsection b) of Article 24 of the LRTA, the arbitral decision on the merit of the claim for which no appeal or challenge is available binds the tax administration from the end of the period set for appeal or challenge, and the latter, in the exact terms of the merit of the arbitral decision in favor of the taxpayer and until the end of the period set for the spontaneous execution of sentences of the judicial tax courts, "restore the situation that would exist if the tax act that is the subject of the arbitral decision had not been made, adopting the acts and operations necessary for that effect."

In the legislative authorization on which the Government based itself to approve the LRTA, granted by Article 124 of Law No. 3-B/2010, of 28 April, it is proclaimed, as the primary guideline of the institution of arbitration as an alternative form of jurisdictional resolution of disputes in tax matters, that "the tax arbitration process must constitute an alternative procedural means to the process of judicial impugnation and to the action for the recognition of a right or legitimate interest in tax matters."

With respect to the claim for condemnation to payment of compensation for undue provision of guarantee, Article 171 of the Tax and Customs Procedural Code establishes that "compensation in case of bank guarantee or equivalent improperly provided shall be requested in the process in which the legality of the debt to be executed is disputed" and that "compensation must be requested in the appeal, impugnation or challenge or, if its ground is subsequent, within 30 days after its occurrence."

Thus, it is unequivocal that the judicial impugnation process encompasses the possibility of condemnation to payment of undue guarantee and is, in principle, the appropriate procedural means to formulate such a claim, which is justified by evident reasons of procedural efficiency, since the right to compensation for undue guarantee depends on what is decided regarding the legality or illegality of the assessment act.

The request for constitution of the arbitral tribunal and for arbitral pronouncement has as a corollary that it will be in the arbitral process that the "legality of the debt to be executed" will be discussed, whereby, as results from the express tenor of paragraph 1 of the aforementioned Article 171 of the Tax and Customs Procedural Code, it is also the arbitral process that is adequate for appreciating the claim for compensation for undue guarantee.

Moreover, the cumulation of claims relating to the same tax act is implicitly presupposed in Article 3 of the LRTA, in speaking of "cumulation of claims even if relating to different acts," which shows that the cumulation of claims is also possible with respect to the same tax act and claims for compensation for indemnifying interest and condemnation for undue guarantee are susceptible to being covered by that formula, whereby an interpretation in this sense has, at least, the minimum of verbal correspondence required by paragraph 2 of Article 9 of the Civil Code.

The regime for the right to compensation for undue guarantee consists of Article 53 of the General Tax Law, which establishes the following:

Article 53

Guarantee in case of undue provision

1. The debtor who, to suspend execution, offers bank guarantee or equivalent shall be indemnified totally or partially for the losses resulting from its provision, if it has been maintained for a period exceeding three years in proportion of success in administrative appeal, impugnation or challenge to execution that have as object the debt guaranteed.

2. The deadline referred to in the preceding number does not apply when there is found, in administrative appeal or judicial impugnation, that there was an error attributable to the services in the assessment of the tax.

3. The compensation referred to in paragraph 1 has as maximum limit the amount resulting from the application to the guaranteed value of the rate of indemnifying interest provided for in this law and may be requested in the administrative appeal or judicial impugnation process itself, or autonomously.

4. Compensation for provision of undue guarantee shall be paid by deduction from the revenue of the tax of the year in which payment is made.

Naturally, the losses to which paragraph 1 of the cited Article 53 alludes are encompassed not only the premiums and other expenses paid to the Bank for the provision of the guarantee but any other lost profit or emergent damage. Everything, however, limited in accordance with what is established by paragraph 3 of Article 53 of the General Tax Law.

In the case in question, it is manifest that the errors in the Corporate Income Tax assessment act are attributable to the Tax Authority, since the corrections were of its initiative and the Claimant in no way contributed to those errors being made.

For this reason, the Claimant has the right to compensation for the guarantee provided.

V. DECISION

In light of the foregoing, the claim for annulment of the tacit dismissal and the claim for allowance of the Administrative Appeal are judged well-founded, and the Corporate Income Tax assessments for the fiscal years 2008, 2009 and 2010 are accordingly annulled, as well as the corresponding assessments of compensatory interest.

The Tax Authority is further condemned to payment of compensation for undue provision of guarantee to be determined in the execution of judgment, since no elements for the determination of the compensation result from the proceedings.

Value of the case: In accordance with paragraph 2 of Article 315 of the Civil Procedure Code and paragraph 1 of Article 97-A of the Tax and Customs Procedural Code and paragraph 2 of Article 3 of the Regulation of Costs in Tax Arbitration Proceedings, the value of the case is set at € 108,125.04

Costs: Pursuant to paragraph 4 of Article 22 of the LRTA, I set the amount of costs at € 3,060 (THREE THOUSAND AND SIXTY EUROS), calculated in accordance with Table I of the Regulation of Costs in Tax Arbitration Proceedings based on the value of the claim, at the charge of the claimant.

Notify the parties accordingly.

Lisbon, 21-7-2014

The arbitrators,

José Poças Falcão

António Rocha Mendes

Armindo Fernandes Costa

[1] The Claimant submitted, within the respective period, submissions but not relating to the present case [they were relating to case No. 59/2013-T] and which, for that reason, were not considered [see order of 24-4-2014].

[2] At the end of execution of the contract, the difference between expenses incurred - in the amount of € 27,487,606.01 - and revenues obtained - in the amount of € 21,806,250.00 - result in a loss in the amount of € 5,681,356.01.

[3] This Accounting Standard and Financial Reporting (NCRF) is based on the International Accounting Standard IAS 11 - Construction Contracts, adopted by the original text of Commission Regulation (EC) No. 1126/2008, of 3 November.

Whenever in this standard there are references to international accounting standards, it is understood that these refer to those adopted by the European Union, in accordance with Regulation (EC) No. 1606/2002 of the European Parliament and of the Council of 19 July and, in accordance with the original text of Commission Regulation (EC) No. 1126/2008 of the Commission, of 3 November.

[4] The Official Chart of Accounts and Accounting Guideline 3 were silent as to which elements should be accepted as contract revenues.